Inflation-Linked Bonds Boom

Inflation-Linked Bonds Boom

Governments in Emerging Markets Plan New Issues

ANJANI TRIVEDI

Governments in emerging markets are turning to inflation-linked bonds, some for the first time, as they look to tap more avenues to raise cash and signal they’re serious about keeping a cap on price increases. An Indian trader counted money at a wholesale market in Hyderabad. A fourfold surge in the cost of onions helped push Indian inflation to a seven-month-high in September.India issued its first, conventional inflation-linked debt this year and said there is more on the way, while the Philippines plans its debut early next year. In total, Brazil, India, Turkey and Thailand issued $12.7 billion so far this year, up 27% since last year according to Thomson Reuters Eikon, a market data provider, and adding to the approximately $550 billion emerging markets inflation-indexed bond market.

The boom is good news for buyers wanting protection from accelerating inflation as interest payments on these bonds are linked to consumer price indexes. After years of tepid inflation across the globe, emerging market prices are rising, which spells bad news for holders of regular bonds whose fixed payments will reduce in value.

The International Monetary Fund expects inflation in emerging markets and developing economies to be 4.4% and 4.5% in 2013 and 2014, respectively, and 1.6% and 1.8% in advanced economies.

Investors say inflation-linked bonds give them a sense of security that a government is serious about not letting inflation spiral out of control, because it will be forced to pay more if prices rise.

“Governments are issuing these bonds because they are a natural extension of developing their local debt markets, which in and of itself is a positive milestone,” said Robert Abad, an emerging-markets portfolio manager at Western Asset, a subsidiary of Legg Mason LM -1.96% Global Asset Management, which manages $670 billion. “The bigger the local debt market, the less governments have to rely on” raising debt in foreign currencies.

Developed economies too have been issuing inflation-protection bonds, with Japan issuing its first so-called linker in five years in October and New Zealand selling again this year after returning to the market in 2012 for the first time in 13 years.

Still, for much of this year, demand has been lukewarm with international investors saying valuations weren’t accurately reflecting the risks they had to take on with yields too low.

The U.S. Treasury’s inflation-protected securities have slumped 8% this year while India’s linkers weren’t well received earlier this year. The bonds were issued at 1.44% over the Wholesale Price Index, the main inflation gauge, which rose to 7.00% in October, compared with the 2.06% real or inflation-adjusted yield on the 10-year Indian governments.

The Barclays Emerging Markets Government Inflation Linked Bond Index, which measures the performance of inflation-linked bonds in major emerging economies, is up 2.4% since early September, after having dropped 5.1% in the first eight months of the year.

“Up until now, we have avoided many of the emerging market issuers, predominantly because of valuations,” said Martin Hegarty, co-head of BlackRock Inc.’s global inflation-linked $25.5 billion portfolio. “But at current valuations we are looking at them a lot more seriously.”

Mr. Hegarty says BlackRock is buying New Zealand linkers and investing in Brazil’s, one of the largest emerging market inflation-linked bond issuers, as it makes more sense now after the country dropped a 6% tax on fixed-income investments.

The market for inflation-protected bonds in many emerging economies is still small and capital controls make it difficult for investors to buy and sell securities, making them wary of entering in the first place. Local pension funds and insurers tend to be the biggest buyers.

“Market liquidity in [the] secondary” market is the biggest challenge to emerging market inflation-proof bonds, said Stephen Chang, head of Asian fixed income at J.P. Morgan Asset Management. Mr. Chang says he has seen interest in linkers from global local currency debt funds.

Fund managers say their clients have been asking about emerging market linkers because they offer exposure to local currencies.

Guillermo Osses, head of emerging markets debt at HSBC HSBA.LN -1.15% Global Asset Management, says the recent interest has been focused on bonds issued by countries where currencies depreciated during the summer rout.

“For us, the currency decision comes well before we decide whether to buy a nominal or inflation-linked instrument,” said Mr. Osses. HSBC’s approximately $200 million emerging markets inflation-linked bond fund, which is part of its $15 billion emerging markets strategy, has seen a slight uptick in assets.