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Baht/$ 33.57/60 (Bid/Ask)
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GOLD |
14,050
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ECO CAFE'
TIENTIP SUBHANIJ
Inflation is of increasing concern around the world. Investors are waking up to the fact that rising living costs will erode the purchasing power of their savings. For investors, inflation is no doubt their number one enemy. Some analysts even say that depositors or bondholders look at inflation the way Superman looks at kryptonite.
Because inflation looks scarier than before, a lot of investors have become interested in securities that can be hedged or reduce the risk of inflation.
Although relatively new for many investors, inflation-protected securities are not new in the global financial market. The idea can actually be traced back to the year 1790 when the State of Massachusetts issued a bond linked to the price of a basket of goods.
The concept of inflation-protected securities has also long been discussed in academic literature. Several renowned economists including Irving Fisher, John Maynard Keynes and Milton Friedman have all supported the ideas of inflation-protected bonds, but for some reasons they failed to convince the government officials of the day to issue such securities.
In terms of the historical development of the inflation-protected securities markets, Chile (in 1956) and Brazil (in 1964) were among the first to issue the securities, largely because of their volatile inflation environments. Later, during the 1980s and early 1990s, Australia, New Zealand, Sweden and the United Kingdom all started to develop inflation indexed programmes as a deliberate disinflationary policy choice. More recently, industrialised countries, for instance, the United States (in 1997), France (1998), Japan (2004) and Germany (2006),began to issue inflation-linked securities, but more or less for the purpose of completing their already developed financial markets.
In the marketplace, the terms "inflation-protected", "inflation-linked" and "index-linked" are used interchangably. Often they are briefly referred to as "linkers". In the United States they are officially called Treasury Inflation-Protected Securities, or Tips.
The inflation-linked market has grown rapidly in the last several years. The US market for inflation-linked securities is the largest in the world, followed by the UK and French markets. As of 2008, the sizes of US, UK, and French linker markets were approximately $500 billion, $320 billion, and $210 billion, respectively, accounting for about 32%, 21% and 14% of global government inflation-linked securities.
In Thailand, the Public Debt Management Office recently expressed its interest in offering inflation-linked bonds for institutional and retail investors to hedge against inflation. Details have not been disclosed yet, but the issues are expected to be part of the funds raised for the 2009 fiscal year starting this coming Oct 1.
An interesting aspect of inflation-protected securities is that they are the only asset class that provides systematic protection against inflation. Particularly, they have an interest rate that does not change throughout the life of the security. But the principal amount used to calculate the interest payment does change, based on inflation.
Let's look at how linkers work. Consider a 10-year inflation-indexed security that has a par value of $10,000 and an annualised interest rate of 4%. If during the first year after the bond was issued, the inflation rate as measured by the consumer price index is 3%, the new principal amount is adjusted up to $10,000x1.03 = $10,300. And the annual interest payment would be $412 (or 4%x$10,300). Assume further that the inflation rate over the second year is 2%, this will result in a new principal of $10,506 ($10,300x1.02), and an interest payment of $420 (4%x $10,506). The procedure continues over the life of the security, and at maturity we receive the inflation-adjusted principal.
Although the specifications of linkers differ widely across markets, their basic formulation is the same. The inflation adjustment is usually calculated based on a lagged value of the relevant price index, so that when the coupon payment is due, the exact amount to be paid will be known. The index used is usually a commonly available price index. In addition, a number of linkers have a deflation floor provision, guaranteeing the greater of their inflation-adjusted principal or par amount at original issue.
If the investor wants to sell the linker before the maturity date, he or she can sell it in the secondary market to other investors, just like other debt securities.
In terms of return, the interest rate of a linker is lower than those of conventional securities because the issuer of such a security is taking the risk of inflation heating up. Lnkers are therefore quite a good buy if inflation is high, but may have an inferior return if inflation is low.
There are other interesting aspects of inflation-protected securities that are worth mentioning. And so we will talk about them in my next column.
Dr Tientip Subhanij holds a PhD in economics from the University of Cambridge, and currently has a career in banking as well as academia. She can be reached at tien201@yahoo.com
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