Inflation in the eurozone is rearing its head. Any comprehensive inflation-hedging strategy should probably combine multiple asset classes. However, inflation-linked bonds, whose coupons are made up of a fixed rate plus a variable top-up that covers for moves in consumer prices, remain a favoured first line of defence.
The Inflation Outlook
Inflation in the eurozone has spiked markedly in the space of a few months. The harmonised index of consumer prices, or HICP, hit 2.0% year over year in February, its highest level since January 2013. Only six months earlier it was just managing to keep afloat at zero.
Annual HICP calculations have been inflated by “base effects” in the energy price component of the index. Put differently, oil prices–currently stable around USD 55 per barrel–are much higher than a year earlier. The noise generated by the base effects is expected to wear off soon, and eurozone HICP may drift down and settle at slightly lower levels.
The core measure of HICP, which excludes volatile energy and fresh food prices, has remained remarkably stable for the past 18 months at around 0.8%-0.9%. More importantly, measures of medium-term inflation expectations–for example, 5-year/5-year inflation swaps–remain below the ECB’s price stability target of 2.0%. This is also reflected in the latest round of economic forecasts released by the ECB, which foresee HICP averaging 1.7% in the period 2017 to 2019.
The reason for the current jump in inflation is not one that would require the ECB to consider any policy action, such as a hike in interest rates, at this stage. Nonetheless, eurozone HICP hitting 2.0% has been an interesting turn of events for an economy routinely described in the past few years as being at high risk of falling into a Japanese-style deflationary vortex.
Indeed, market participants seem increasingly confident that the ultra-easy monetary policy measures implemented by the ECB have effectively put the spectre of deflation to rest. And so, if anything, this is a good occasion to remind investors about the dangers of failing to protect portfolio returns against the eroding effects of inflation.
The Eurozone Inflation-Linked Bond Market
The eurozone inflation-linked government bond market has developed during the past two decades. Kick-started by France, first with bonds linked to the domestic consumer price index and since 2001 also to the eurozone HICP, excluding tobacco prices, it now also counts Italy, Germany, and Spain as regular issuers.
The eurozone-linked bond market now stands second in terms of outstanding volume and turnover to the United States, with annual sales representing 10%-15% of all eurozone government bond issuance.
In terms of size and regular issuance activity, this is a market dominated by France and Italy. By our calculations, France accounts for 45% of the total outstanding of inflation-linked government bonds in the eurozone, Italy follows at 33%, Germany at 15%, and Spain the remaining 7%.
The Case for a Passive Investment Approach
Passive funds have proved a good option to gain exposure to the eurozone inflation-linked bond market. The opportunities for active managers to add meaningful value have been severely constrained in this era of ultralow interest rates and proactive monetary policymaking.
In our view, this is likely to continue in a scenario where the ECB changes tack. A less easy policy stance, involving the unwinding of quantitative easing and higher interest rates, would favour duration-shortening strategies. However, the eurozone inflation-linked bond market is already biased to the short and medium segments.
Two Highly Rated ETFs
There are several offerings in passive space – both ETFs and traditional index funds – providing exposure to the market of eurozone inflation-linked bonds. We have awarded a Morningstar Analyst Rating of Silver to Lyxor EuroMTS Inflation-Linked Investment Grade ETF (MTI) and iShares Euro Inflation Linked Government Bond ETF (IBCI). This conveys our conviction that these two funds are well-placed to deliver returns above their category peers–both passive and active–over a full market cycle.
The Lyxor ETF tracks the FTSE MTS Mid Price Investment Grade Inflation Linked Aggregate All-Maturity Index. The ETF is physically replicated and comes with an annual ongoing charge of 0.2%. Within the context of its category, the Lyxor ETF has delivered returns ranking in the first quartile on a three-, five-, and 10-year trailing basis.
The iShares ETF tracks the Bloomberg Barclays Euro Government Inflation Bond Index. The ETF is physically replicated and levies a slightly higher ongoing charge of 0.25%. At first sight, the fee looks a bit toppy. However, its tracking difference has routinely come in below the ongoing charge, partly thanks to revenues generated by securities lending. In 2016, the ETF lent out an average of 28% of its assets for a net return to the fund of 4 basis points.
In the past decade the iShares ETF has lagged the Lyxor ETF and the category average. In fact, its returns have ranked in the third quartile during the past five- and 10-year trailing periods on a risk-adjusted basis. So why give it a Silver rating?
Until April 2015, the index tracked by the iShares ETF excluded bonds with an investment-grade credit rating below A3/A-. This had led to the exclusion of Italy and Spain, and so the ETF failed to capture the strong upside to eurozone peripheral bonds post-mid-2012.
The index now applies a standard eligibility criteria, covering all investment-grade rated issuers irrespective of qualification. Italy and Spain are back in the basket. This makes the index truly reflective of the underlying market and, more importantly, places the ETF on an even keel in future performance terms relative to other all-country-encompassing trackers. One should not overlook that the Morningstar Analyst Rating is a forward-looking qualitative assessment, and in the case of this iShares ETF, the adage of “past performance is no guide to the future” rings especially true.
