The emerging markets and commodities boom along with the effects of the economic stimulus packages mean pension schemes and the wider institutional investment sector have found themselves struggling to make sense of inflation expectations.
Jon Masters, Head of Property Derivatives at BGC Partners, says: “With the uncertain investment environment, high inflation and potential regulatory change it makes sense for pension funds to consider ways to protect investment returns using the latest risk management tools. In the case of property this entails utilising derivatives.”
He continues: “By using a blended RPI/Property Linked Note a pension fund can protect its portfolio against the erosive nature of inflation with no basis risk whilst giving property returns and capital guarantees in a quicker and more effectual way than buying or selling various sector specific assets within that property portfolio.”
From analysis undertaken by BGC he states: “In the case of commercial property investment, rental income vastly improves the performance of commercial real estate returns relative to RPI. Therefore, it is sensible to protect the income element from the erosive nature of inflation… Secondly, the residential sector is a good inflationary hedge and diversifier within a portfolio. Using property derivatives, pension funds can now gain synthetic exposure to the returns of the residential market without any of the traditional tenant / ethical dilemma risk or management burden, associated with ownership of the physical asset.”
Stephen Jones, Co-Head of Fixed Income at Aegon Asset Management believes that countering the emergence and persistence of inflation requires a specific and dedicated investment response. “Our Inflation Linked Fund seeks to deploy a multi asset approach to firstly offset some of the expense seen in the core index-linked asset, and secondly capture price moves at all stages of the price pressure pipeline. Therefore the fund can and does invest in commodities, equities, credit, foreign exchange and interest rates around a core holding of index linked bonds sourced from the UK and overseas government markets. In so doing, we are taking exposure to the causes of inflation as well as assets that benefit from the end result.”
In terms of how the inflation options market has developed and what is driving the demand, Nicolas Tabardel, Global Head of Inflation Volatility at Deutsche Bank, notes: “The growth in volumes has been phenomenal. Last year we had a growth spurt in the market, combined interbank volumes for Europe and the U.S. trebled from $13bn in 2009 to $50bn in 2010. If you look back, in 2004 this market didn’t exist and in 2005 the market traded $1bn. Volumes have been roughly doubling every year on average, so it’s very fast growth.”
On the main trading themes in this market Tabardel suggests: “In the UK we have demand for floors from pension schemes but we also have supply of caps, so that’s the only market where caps are available in large size and are cheap. It seems that everybody wants to buy inflation caps, the only place where caps are cheap is the UK but nobody wants to buy them here.”
Explaining the rationale of using inflation options he concludes: “Many of our clients are exposed to inflation risk and inflation volatility risk in one form or another. We see pension funds that have LPI (liability driven investment) liabilities; we see real estate investors receive LPI linked rent and we see bond investors buy TIPS (treasury inflation protected securities) and therefore hold inflation flows. Both of these are good reasons to use inflation options.”
Looking to other protection options, David Donora, Head of Commodities at Threadneedle Investments, remarks that commodities remain an effective strategy: “They have long been recognised as a credible hedge against inflation, especially unexpected inflation. Commodities continue to provide protection against inflation and its destructive effects, particularly as long as emerging markets growth remains robust and developed market governments continue to deploy unorthodox economic policies.
The Clear Path Analysis report, ‘Inflation Hedging for Institutional Investors,’ highlights what a heightened inflation environment means and what can be done about it.