roundtable discussion

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australian inflation in a world of macro challenges

ParticiPantsn Ben Alexander Principal ARDEA INVESTMENT MANAGEMENT n Andrew Banbury Director, Global Rates Trading DEUTSCHE BANK n Stuart Dear Senior Investment Manager, Fixed Income ABERDEEN ASSET MANAGEMENT n Rod Everitt Head of Australian Dollar Syndicate DEUTSCHE BANK n Julian Foxall Portfolio Manager PIMCO n Vaughan Harvey Director, Global Rates Trading DEUTSCHE BANK n Tim Hext Head of Balance Sheet & Funding NEW SOUTH WALES TREASURY CORPORATION n Tim Jordan Environment Social Governance Analyst DEUTSCHE BANK n Darren Langer Head of Portfolio Management TYNDALL INVESTMENTS n Annette Mullen Senior Portfolio Manager, Global Fixed Interest & Credit COLONIAL FIRST STATE GLOBAL ASSET MANAGEMENT n Rob Nicholl Chief Executive Officer AUSTRALIAN OFFICE OF FINANCIAL MANAGEMENT n Tano Pelosi Portfolio Manager ANTARES FIXED INCOME n David Plank Managing Director, Head of Macro Research & Strategy Australia DEUTSCHE BANK n Nick Tribe Senior Portfolio Manager, Internal Fixed Income VICTORIAN FUNDS MANAGEMENT CORPORATION n Kent Wilkes Director, Inflation QUEENSLAND INVESTMENT CORPORATION n Matthew Yencken Managing Director, Debt & Derivatives, Institutional Client Group DEUTSCHE BANK

Moderatorsn Honor McFadyen Managing Director, Head of Sovereign & Real Rates DEUTSCHE BANK n Laurence Davison Editor KANGANEWS

ustralia’s inflation-linked bond market has quietly built volume

and liquidity since the return of the Australian Office of Financial

Management (AOFM) to issuance in 2009. A Deutsche Bank and

KangaNews-hosted roundtable held at the end of May discussed the growing

relevance of the market in the context of Australia’s inflation outlook.

a

AUSTRALIAN OUTLOOK

davison Before we talk about the market for inflation, let’s discuss the outlook. david Plank, what is deutsche Bank’s view on the inflationary outlook for australia within the context of the global economy?n Plank Two themes are particularly worth discussing here. One is our inflation forecast for Australia to the end of 2013, with one driver being the carbon price – which we will come to later in this discussion. The second is the risks around the forecast. These are obviously are fairly large. In the short term they relate to the potential for a worst-case scenario unfolding in Europe and the prospects of a sharper slowdown in China. In the longer term the risks are posed by the global policy environment and the two-way impact this might have on inflation.

The profile for inflation in Australia includes an expected big impact from the carbon price and the change to the tax rebate on insurance, both of which are coming in the third quarter of this year. Our expectation is for CPI to jump by 1.6 per cent in that

quarter alone – which obviously means a great deal for the 2015 Commonwealth inflation-linked bonds in particular. From that point onwards our assumption is for CPI of around 0.7 per cent per quarter, absent big exogenous factors.

This means our expectation is for headline inflation to bottom out at around 1.5 per cent in the middle of 2012 then peak at around 3.8 per cent in March next year, before returning to a little under 3 per cent by the end of 2013.

The 2.5-3 per cent range is, in a sense, our default expectation for Australian inflation without external drivers, and it is the middle of the Reserve Bank of Australia (RBA)’s target band. Unless we start to feel that the RBA is not going to do its job, our expectation will always be around these levels. Obviously, the near term can be driven by specific policy measures – such as the carbon price – or by big shifts in commodity prices.

davison and what about the risks around that forecast – especially as they relate to the macro environment?

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n Plank It’s interesting to think about what happened in 2008 in this context. In the second half of 2008, especially the final quarter, headline inflation plunged: the CPI print was minus 0.3 per cent in Q4 and annual inflation fell from a peak of 5 per cent in September 2008 to a low of 1.3 per cent a year later.

If we get something similar to the financial crisis this year, the question will be whether we could see a similar plunge in inflation. Headline inflation is now only 1.5 per cent, so even if we see an event like the financial crisis there is not the ability to fall as far – unless we are talking about negative inflation.

The other thing that drove the very large fall in inflation in Q4 2008 was oil. The oil price fell to US$40 per barrel at the end of 2008, from US$140 a barrel in July that year. This meant that, even with a big drop in the value of the Australian dollar, in Q4 CPI there was a minus 18 per cent contribution from petrol prices. Again, the oil price now is US$90 a barrel so even if it halved it would not have the same impact unless the Australian dollar significantly outperformed.

The three unknowns for the next year’s outlook are whether the worst-case scenario happens in Europe, how much

– if that environment unfolds – commodity prices fall, and the extent to which the Australian dollar reacts to the global environment. There could, for instance, be a ‘safe-haven bid’ in the Aussie dollar that prevents the kind of plunge we saw in

mid- to end-2008.My view is that we are

not likely to get the same percentage price decline in oil prices as we did in 2008/09 simply because the starting point is lower. The price can’t realistically go to US$10 per barrel because the reality is that below US$40 a barrel supply problems will start to emerge. That limits the extent to which prices can fall.

On the other hand, I expect the currency to be a bit more resilient – because, given what is happening in Europe, there aren’t many alternative places to put your money. How much more is impossible to know.

If the worst-case scenario unfolds in Europe, our forecast for headline Q3 CPI – which we currently expect to be 1.6 per cent – would be muted by a fall in petrol prices. There

would likely be a much smaller CPI figure in that quarter, though probably not a negative because of the scale of the impact of carbon prices and the health insurance tax. Headline

“The problem wiTh any expecTaTion ThaT we will have a loT more inflaTion five or six years down The Track is ThaT To geT There, cenTral banks eiTher need To fail To meeT Their inflaTion TargeTs or To have Their mandaTes changed.”DaviD Plank Deutsche Bank

“we are a long way from having inflaTion-linked bonds become a core parT of The superannuaTion indusTry. The only way To do This is in incremenTal sTeps.”annette Mullen colonial First state GloBal asset ManaGeMent

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n Wilkes We currently assign a reasonably low probability to the Japanese-style outcome and a somewhat higher probability to the inflationary outcome. But we think this is most likely to occur via stealth rather than through an explicit change to central bank mandates.

We believe there are very large differences between the situation in Japan and that being experienced in the US, for example. In addition to the relatively swift adjustment of the private sector compared with Japan, the key difference has been the quick and large action on behalf of central banks.

This has not only provided a key macro boost via its impact on risky assets and lower bond yields, but at the same time it has also kept inflation expectations relatively anchored. In some cases – and, again, this is a key difference from Japan – central banks have engendered an increase in inflation expectations, providing an additional macroeconomic boost at the zero bound in nominal cash rates through its impact on real cash rates. By the time the Bank of Japan took its

cash rates to zero, Japan had been experiencing deflation for several years and it was already becoming entrenched in expectations.

This anchoring of inflation expectations is, in our opinion, a key reason to believe permanently negative inflation rates are an unlikely outcome. We also believe it is unlikely that an explicit change in central bank mandates will occur. A politically-motivated change to central bank targets seems unlikely in the next few years, in our opinion. However, it is likely that over the longer term, and once more normal economic conditions emerge, greater debate will emerge around whether existing inflation targets are too low to protect against the risk of deflation going forward.

inflation could fall to just over 1 per cent by the end of this year, then rise over 2013.

HIGHER TARGET BANDS

davison what could those kinds of impacts have on the medium-term outlook?n Plank It depends on whether you think the world will follow the Japanese model, meaning a debt dynamic that demands deflationary pressures, or whether the impact of too much debt – especially in Europe, given its demographic issues – will demand an inflationary response. In other words, if the only way to deal with sovereign debt is to inflate it away.

The problem with any expectation that we will have a lot more inflation five or six years down the track is that to get there, central banks either need to fail to meet their inflation targets or to have their mandates changed. If you assume central banks will perform to their mandates – which, in Europe, means low inflation by definition – it’s hard to see how the inflationary pressure will come through.

To have a much higher inflationary environment in the next few years, the institutional arrangements in place would have to change. Absent that, the more likely risk on a two- or three-year horizon is that we face the kind of deflationary pressures experienced by Japan.

Australia is also different from much of the developed world, in that we don’t have the same debt dynamics or the same demographic pressures. We also have a better nominal income picture. This suggests the RBA will be able to avoid downside inflationary surprises but will also have scope to manage the upside.

“i am noT sure if ausTralia is really as differenT from europe as iT mighT appear. if cenTral bank regimes were To change, globally, To allow more inflaTion, i am noT sure how The rba could possibly sTand againsT ThaT.”Ben alexanDer arDea investMent ManaGeMent

Matthew Yencken, deutsche Bank Rod Everitt, deutsche Bank Honor McFadyen, deutsche Bank Andrew Banbury, deutsche Bank

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austerity and growth, and one very easy – if not attractive – solution is to allow some more inflation. So the idea of changed central bank mandates is not inconceivable.

I am not sure if Australia is really as different from Europe as it might appear. If central bank regimes were to change, globally, to allow more inflation, I am not sure how the RBA could

possibly stand against that. If Europe starts to target 4 per cent inflation, it is unlikely that Australia’s target of 2-3 per cent would remain achievable.n Plank There is a risk there as well, in the sense that it may be hard to let inflation rise to 4 per cent without it inevitably going upwards from there. It would be difficult to retain the credibility of the institutions involved as they move their targets upwards.n alexander If price stability initially means 2 per cent inflation and then changes to mean 4 per cent inflation, people will inevitably worry about what it might mean in future. But it

doesn’t follow that the concern would mean it is impossible for that path to be taken.

FISCAL FIREPOWER

n dear I think it is also worth pointing out how much more constrained policymakers are in terms of their ability to respond in the near term than they were in 2008. Monetary policy is compromised in most places, and fiscal policy is weakened.

n Plank If we are hit by the same kind of shock as we had in 2008/09, Australia’s fiscal position for 2012/13 would be running a deficit in the region of 5 per cent of GDP – with no discretionary decisions factored in. Discretionary decisions as aggressive as what we saw in 2009 would make that more like 8 per cent – which makes me doubt whether government would do the same again.

What this means is the responsibility falling to the RBA to find the right cash rate for that kind of environment. It’s impossible to know what that would be. But if we calibrate from what the RBA did in 2009, with a bit more margin for bank funding rates above the cash rate, to get to the same level of interest rate stimulus this time round the cash rate

n tribe With the slowdown we are seeing in parts of the world, particularly Europe, it is clear to see that governments are keen to ensure their economies recover over time, but and that will likely mean they are willing to accept higher inflation going forward. In the US, where the economy is performing reasonably and there has been plenty of monetary stimulus put in place to support the economy, there may already be pressure for inflation to move higher. But I am not convinced there is enough reason for near-term concern.

I don’t expect central banks anywhere to publicly acknowledge an increase of their target inflation levels – it could be a product of the policies they put in place. Once the whole world, in aggregate, starts to grow again – which seems to be a fair way ahead – it may be time to start worrying about that.n dear It is possible that there will be an impact from productivity in the Australian context, and what that might mean for inflation assumptions. The high Australian dollar could be seen as an opportunity to improve productivity. But I wonder if there are any considerations about the direction of unit labour costs over the medium term.n Plank Essentially, we don’t forecast it. The assumption is that the RBA will achieve an inflation outcome within its target band. If productivity turns out to be bad we will get there with lower growth and higher unemployment. If productivity is good we will get there with higher growth and lower unemployment.n alexander I agree with the idea that the risks to inflation in the next two or three years are clearly on the downside. I also agree that you have to think about changes in regimes for central banks in order to get interested in upside inflation risks further out. Europe’s challenge is trying to achieve both

“iT is cerTainly noT definiTively The case ThaT inflaTion TargeTing has, of iTself, creaTed lower inflaTion ouTcomes. ouTcomes have probably been more To do wiTh global ouTpuT gaps and globalisaTion generally.”tano Pelosi antares FixeD incoMe

David Plank, deutsche Bank Tim Jordan, deutsche Bank Vaughan Harvey, deutsche Bank

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would need to fall to 2.5 per cent or possibly slightly lower. If the central bank needs to do more than that – because fiscal policy is not helping out and the currency may not be as stimulatory – we would be looking at a cash rate of something like 1.5 per cent.

The counter to this is that the US banking system is in a lot better shape than it was in 2008/09. So even if there is a catastrophic event in Europe it won’t entail the same in the US. Even with fiscal policy helping less, the RBA won’t have to do as much – especially if China responds as well.

davison What specific impact is Deutsche Bank forecasting from the arrival of the carbon tax in Australia?

Jordan From an inflation perspective the two most important questions are when it will be in place and what the price will be, especially after the fixed price period ends in 2015. It is also worth considering

how Australia’s price will compare to global equivalents – and whether there could be pressure to harmonise pricing – and what the various scenarios for repeal could be.

The European carbon price is low at present: it is trading at about €6-7 (US$7.5-8.8) per tonne, with the quite strongly-correlated CER price at about €4 per tonne. That price is largely driven by economic activity in Europe. In light of the downturn and the prospects for recession, demand for electricity is low and therefore so is the price of carbon.

European companies have also largely been over-allocated free

permits. So while the scheme has at times been short individual players – especially in the industrial sector – as a whole it has tended to be long since the beginning.

This means Australia’s price looks quite high relative to where Europe is trading. But it is important to remember that the carbon price is not the only thing being done

to reduce climate change, and the low carbon price in Europe reflects in part other measures being used to push down electricity demand.

When you add those things back in, the real carbon price in Europe is much higher, though Australia’s is still relatively high.

It’s also clear that the next Australian election could see an incoming government with a stated commitment to repealing the carbon tax.

My sense, though, is that the Senate could stand in the way of a repeal. The Senate is typically a problem for incoming governments; it is

rare for both houses to be controlled after a change in government because only half the Senate is re-elected every three years. It would take an absolute landslide for an incoming government to take control of the Senate.

Jordan One scenario is that there is not just a change of government but one in which the new government controls both chambers of parliament. That would allow a move to repeal the carbon price quite quickly.

Even so, if the current government runs its full term the election will be scheduled between August and October 2013. And it would be quite disruptive to break the carbon price during its first financial year – it comes into force on July 1 2012.

If a new government needs a double dissolution to win control of the upper house, we would be looking at another eight to 14 months after the 2013 election before it happened, with risks of extension at all the interim steps. The quickest timetable under that scenario would allow for repeal in around May 2014 – just short of two full years after coming into effect.

The question in that case is whether there would be the same urgency around a repeal

Taking The TemPeraTure of carbon pricingAustralia’s carbon pricing regime has passed into law and will come into effect in July 2012. Beyond those facts, the likely impact of carbon pricing – and the likely longevity of the law as government change looms – is a matter for debate.

in that kind of timescale. And what it all means is that we are likely to have the carbon price for at least one year and possibly two, with the outcome turning on the precise result of the 2013 election.

The electricity market is not trading beyond the end of 2013 at the moment – there is no liquidity in it. Firms that are trying to hedge their exposure cannot do so, which we attribute to uncertainty about the carbon price outcome.

McFadyen What is the outlook suggested by the electricity market at present, and how does that factor in to inflation pricing?

harvey The electricity market currently has about A$9 (US$8.8) of carbon priced into it for the end of 2014. There is too much noise coming from global events to gauge price much beyond a year in the inflation curve. This is also being reflected in price makers’ level of ability to clear risk.

Pelosi We are dealing with factors with opposite impacts. There is a one-step shift in prices coming later this year from the carbon price, but set against that are serious deflationary risks that the market is also pricing in. The uncertainty about possible repeal is being swamped by the macro picture, I think.

harvey That’s right: it is difficult to isolate the impact of the carbon tax on inflation from what is currently happening globally.

“We are likely to have the carbon Price For at least one year and Possibly tWo, With the outcoMe turning on the Precise result oF the 2013 election.”t i M J o r d a n d e u T s c h e B a n k

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n Foxall These assumptions are based on the idea that everyone will react in the same way. But we know there is less firepower, whether fiscal or monetary, to fix a problem like we saw in 2008. This means it could be hard to avoid an inflationary response in the long term. However, in the short term I don’t think there is inflation risk at all, aside from the impact of the carbon tax and other one-off events of that type. It’s certainly not something I think we need to worry about.n Plank In Australia the currency hasn’t appreciated for a year, and non-tradeable inflation is sticky at 3.5 per cent with no sign of falling. A core scenario outlook has Australian inflation rising over the next 12-18 months. And I think there needs to be quite a bit of bad news to stop CPI rising back to close to 2.5 per cent by the middle of next year.n Pelosi I am not convinced that a necessary condition for steepening inflation curves or concern about inflation further out is a weakening of institutions or a shift in monetary regimes. It is certainly not definitively the case that inflation targeting has, of itself, created lower inflation outcomes – particularly when you compare with what has happened in countries without inflation targeting. Outcomes have probably been more to do with global output gaps and globalisation generally.

The other thing to bear in mind is that forecast error, in my opinion, seems to be growing rather than reducing. We have come out of a period that is being referred to affectionately as the ‘great moderation’, during which the variability of output and inflation shrank. It was easier to forecast inflation in that period, and it is a far more difficult proposition when you move into a more difficult and unstable environment. I think the jury is out in terms of where inflation can get to, irrespective of the commitment of central banks to inflation targets.

McFadyen given the macro environment and outlook, how – if at all – have investors changed their inflation-hedging strategies?n langer It is commonly assumed that central banks have inflation under control. But inflation-linked bonds really come into their own when we contemplate the consequences of this

not being the case. Our view is to run a little overweight in inflation at present simply because of that fact. Even if we are in an environment where, over the next few years, economies improve, inflation will likely become a bigger issue.

With real yields as low as they are, it is difficult to say that inflation is the best investment possible. But we see a weighting towards linkers over nominals simply because we believe they will outperform in an environment where we expect yields to rise.

SHORT-TERM SHOCKS

n Mullen From our perspective it is worth mentioning that while policymakers look through one-off inflation events, we have to deal with the consequences of these events. Whether it is Medicare levies, flood levies or the carbon tax in Australia

– where the country is trying to use fiscal restraint – there are impacts. In years to come the same will probably apply offshore. For example, we have already seen the effect of taxes on inflation-linked bonds in the UK.

My point is that we will continue to require inflation-linked bonds even in a low-growth environment in Australia. While core inflation might stay within the policy band, headline

inflation – which is theoretically what we are exposed to – could be above the RBA band. In this type of environment, when you are looking at break-even inflation, inflation-linked bonds potentially still offer good value.

davison how do investors manage against conflicting risks in- and outside australia?n Wilkes Our Australian inflation forecasts are guided by our global macro forecasting models, which are designed to incorporate the influence of a broad range of domestic and

“when The aofm came back inTo The markeT our clienT base Took ThaT as an opporTuniTy To allocaTe back inTo inflaTion, having previously felT They were under-invesTed. we saw ThaT shifT almosT sTraighT away.”Darren langer tynDall investMents

Stuart Dear, aberdeen asset mgt. Annette Mullen, cfs global asst. mgtTano Pelosi, antares fixed income

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international variables. As such, appropriately incorporating the divergent effects of domestic and external factors is a natural part of our forecasting process.

We are modelling a range of outcomes given the Australian opposition’s firm stance on unwinding the carbon tax, if elected. Should our thinking on the probabilities of these outcomes change, we can explicitly adjust.n tribe Broadly, when we think about managing inflation-linked bond portfolios – including, among other things, setting their interest rate strategy – we give consideration to the nearer-term macro environment both domestically and globally. A part of this is the outlook for inflation. But specific short-term inflation impacts have a greater influence on our strategy around where we position the tenor of the portfolios’ inflation risk.n Pelosi We look at different scenarios, and we do a lot of work to assess where the balance of risks lies. The deflationary risk is a clear and present danger. Further out, and somewhat perversely, it speaks to much higher inflationary risk, particularly when we start considering likely policy responses.n alexander It is clear that, when you look at what is priced into the cash rate compared with what is priced into the forward inflation curve, there is not enough fall in the expected inflation price. It looks like a sensible trade to be relatively short inflation, three to four years out, compared with the cash rate.n harvey The market struggles to do that, given the shape of the forward curve – it is so steep. But I agree with the point.n Plank Given the global risks, shouldn’t the appropriate response in Australia be much lower real yields rather than lower break-evens?n harvey That is certainly what has happened recently. I think the offshore fraternity has been very comfortable with real yield

levels in Australia and happy to buy them. It has been harder for domestic investors to get comfortable with where yields are, and I think we now need almost to ignore real yield levels and focus on break-evens.n Pelosi We also have to look at tail risks as well as base cases. Some of the tail risks have seriously pronounced effects, and this has entailed a tug of war in the market between break-even based investors and real-yield players.n dear The driver of the composition of nominal yields has been lower real yields, with relatively stable break-evens – especially compared with 2008/09. But again, we have not had the adverse macroeconomic outcomes we had at that time.n banbury I’m not sure we can use 2008 as a reference because the structure of the market has changed substantially. There is much more liquidity now and we are not seeing the same pace of balance sheet reduction we did in 2008.n Pelosi Still, if someone had told me two or three years ago that we would have a 2015 bond with 40 basis points of yield on it and inflation break-even of around 2 per cent, I would have said that was equally incongruent. The nominal market, at least, is tending towards discounting for a really quite adverse environment.n alexander In general terms I think looking at short-term, one-off episodes of inflation is actually the wrong thing to focus on with inflation-linked bonds. It is more important to

think about the potential for major structural changes in the inflation outlook. From a 10-year bond’s point of view, one year of inflation is almost irrelevant. The potential for deviation is also a lot less on a one-year horizon than on a 10-year horizon.n Plank Except we can be fairly confident that, in 10 years’ time, we will be able to look back and see that the inflation rate has averaged 2.5 per cent.

n alexander What probability would you put on inflation remaining at close to 2.5 per cent over 10 years?n Plank I think it would be around 70 per cent. The question over that horizon is whether Australia becomes overwhelmed by a global inflation trend. I would put the chance of that at about one in three.

If there is an inflation break out from that band I think the likelihood is greater that we would end up above the 2-3 per cent band rather than below it, simply because of the exchange rate and policy regime response. If inflation was consistently below 2 per cent the RBA would react and the government would also be happy to run very stimulatory policy, because the political impact is positive. If inflation is consistently above 3 per cent, and the way to get it back down is to run consistently restrictive policy, I think there is a risk that that would be politically intolerable.

“in Terms of The use of physical bonds versus derivaTives, iT is clear There has been a relaTive shifT in supply, and Therefore liquidiTy, in favour of physicals. ThaT has led To us more acTively changing posiTions via physicals.”stuart Dear aBerDeen asset ManaGeMent

rob nicholl, aofm tim hext, Tcorp

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Over the next decade I don’t expect either of those outcomes, though. Over the next two or three years we likely have a period of low inflation to get through, and I doubt global inflation will be high enough in the seven years after that to push Australia well above 3 per cent.

MARKET ACCESS

McFadyen The aofm returned to inflation-linked issuance in 2009. in the time since then, how have investors changed the means by which they obtain their inflation exposures?n langer When the AOFM came back into the market our client base took the opportunity to allocate back into inflation, having previously felt they were under-invested. We saw that shift almost straight away. Since then our sense is that our clients are happy with what they have got, and there hasn’t been a significant change in allocation since.n tribe The fact that the AOFM has increased its inflation-linked bond issuance has certainly been a positive for the asset class, particularly for funds where inflation plays a prominent role in portfolio construction. The return of the AOFM has also helped the secondary market through the broadening of the range of market participants and improvement in general liquidity.

The AOFM has done a good job in displaying a commitment to ongoing issuance, and its openness and communication with the market has been excellent. The same goes for New South Wales Treasury Corporation (TCorp).

Increased physical bond issuance and the deepening of the market overall has also assisted in the deepening of the inflation swaps market, which continues to play a very important part in the way we manage our inflation-linked portfolio.n Wilkes Queensland Investment Corporation values liquidity highly, particularly with regard to inflation-linked exposures. We have been active in both physical and derivative markets for a long period of time. With regard to Australia, post the syndication of the 2025 inflation linked bond in 2009 liquidity in the physical market has improved significantly. The way we protect investors’ inflation risk has not changed materially. However, AOFM supply over the past few years has enabled us to broaden our opportunity set and seek more efficient outcomes for clients. n dear In terms of the use of physical bonds versus derivatives, it is clear there has been a relative shift in supply, and therefore liquidity, in favour of physicals. That has led to us more actively

changing positions via physicals, though derivatives are certainly still a big part of what we do in the inflation space. It is very much dependent on opportunity.n Foxall On a global basis the main motivation for holding linkers is insurance against inflation as opposed to playing short-term movements. The re-introduction of the linker market in Australia coincided with the financial crisis and a consequent willingness of people to pay for insurance. This is what we see as the driver for the global growth of the linker market.

It is certainly good that the Australian sovereign is back as an issuer. Although the size of the market is not large, it is reasonably liquid. And given Australia currently offers the combination of high rating and high real yields, it is a pretty good place to come for inflation insurance.n Pelosi Prior to the return of the AOFM there was a degree of concern about liquidity. The 2025 bond issue addressed that concern, which I believe has been eliminated going forward. In fact, liquidity is as good as I

have ever seen it – although I also think it was not too bad even prior to 2009.

Generally speaking, good liquidity in the bond market is also good for the swap market. There is an interplay between the two that benefits investors.n Mullen In my view, the increased ability to model inflation is the key difference between the current and pre-2009 inflation-linked bond markets. It was much harder to model the Australian inflation market in the past. Since the AOFM has returned, the market has behaved pretty much as you would have expected: real yields and break-evens are consistently in line with the facts. Before the AOFM’s return we had to deal with a whole series of one-off events, including credit and flow events, which distorted the market.

“increased physical bond issuance and The deepening of The markeT overall has assisTed in The deepening of The inflaTion swaps markeT, which conTinues To play a very imporTanT parT in The way we manage our inflaTion-linked porTfolio.”nick triBe victorian FunDs ManaGeMent corporation

darren langer, Tyndall inv. Julian Foxall, Pimco

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McFadyen Is there a case to be made for the AOFM to offer even longer-dated inflation-linked bonds?

tribe At the moment I think the longest tenor the AOFM has out there is fine. Our appetite may change over time. But the length of the longest AOFM bond – the 2030 – is adequate for the time being.

Wilkes Queensland Investment Corporation is happy with the current term structure. We value liquidity and would prefer to see a focus on building out liquid lines as opposed to pushing out further along the curve. Importantly, any increase in term should be coupled with a nominal comparator to enable investors to make more informed decisions.

alexander There is an opportunity here in Australia for inflation-linked bonds to help change the traditional reliance on equities for duration. The only thing that stops inflation-linked bonds from being an ideal risk-free investment for retirement objectives is that they are too short-dated. In that context it would be good to see the development of a longer-dated government bond market, both in inflation-linked and nominal format.

nicholl How long-dated would you want to see?

alexander Most countries issue 30-year bonds. In the UK there is a 50-year that is being re-opened, and I think the 2020 AOFM bond was close to a 30-year when it was introduced. Let’s start with 30 year issuance.

nicholl Part of our constraint is access to supply volume. If we have A$2 billion (US$2 billion) a year to issue in total it will be hard to develop another liquid line. To be honest, we also don’t see much demand for anything beyond the 2030s at present. And when we do issue another line the most logical next step would be a 2035.

dear A longer-dated nominal line might help develop the market, and encourage demand for a linker.

nicholl Sometimes it seems to us that others are much keener, in general, to see us selling very long-dated bonds than they are on buying them! We have extended the nominal curve, and we plan to consolidate the 15-year point. It might take us a year or two to work through the consideration of whether we want to go beyond that. We spoke to a lot of investors offshore before we issued the 2027 nominal, and although that bond has traded relatively well we recognised that a lot of our investors are constrained by 10-year benchmarks.

alexander If we want there to be both supply and demand, someone has to go first – and it can’t realistically be the investor!

nicholl That’s true. But we can’t lose sight of the supply capacity issue, either. If we had a much bigger programme the answers to these questions would probably look different from what they do under current parameters.

hext Is there any reason why the AOFM couldn’t do A$3-4 billion, rather than A$2 billion,

of annual linker issuance, given it is part of a A$34 billion total programme?

nicholl There are things we want to achieve in the nominal programme as well. We have to balance our gross issuance across the two programmes, and we review this at least annually.

Pelosi One thing we have learned since the 1990s is that investors use the inflation market for insurance, and that insurance is no good if it is offset by rate risk and duration. Hence, I think, the push for shorter-dated inflation-linked bonds. I see a role for longer-dated assets and duration. But there is also a lot to be said for back-filling the curve – especially as we

confront the maturity risk issue and the lumpiness as we go from one maturity to the next.

alexander That is clearly an issue for investors in the way they think about things currently. But as soon as you change your mindset to thinking about the long-dated nature of real liabilities, the price volatility of the asset side can be seen to actually match the liability.

Foxall It comes down to the price you pay for the certainty. There is no doubt that the linker market is relatively

expensive in terms of providing that certainty.

I am not particularly interested in the very short end of the linker market because I believe there are plenty of alternatives to balance the effects of short-term inflation. Over the longer term linkers are a great instrument. But you can’t put all your eggs in that basket anyway – the returns would not be good enough to keep investors happy, even if the certainty would.

yencken While understanding the context of the limits of the AOFM programme, there would be demand for a longer-dated linker. It would also benefit liquidity in the longer-dated end of the swap market.

harvey At the moment the long end of the AOFM curve – the 2027 nominal and the longest-dated linker – offers the best value on an asset swap basis.

McFadyen Tim Hext, what experience has New South Wales Treasury Corporation had with its longer-dated linker issuance, for instance the 2035s?

hext Those were issued back in 2007, with A$500 million of bids for A$200 million of stock. Five years later the line size still hasn’t reached A$1 billion.

oPinions diverge on The 30-year scoreThe inflation-linked bond curve offered by the Australian Office of Financial Management (AOFM) extends to 2030. There is no clear consensus on whether the market would support longer-dated issuance.

“We don’t see Much deMand For anything beyond the 2030s at Present. and When We do issue another line the Most logical next steP Would be a 2035.”rob nicholl ausTralian office of financial managemenT

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We are buying an insurance policy and in that context all we have ever wanted is for that insurance to behave in a proper manner. This market might be small but it is behaving as we want it to – efficiently – especially in the context of the current environment.

davison are investors happy with the granularity of physical bond supply, given the few aofm benchmark linkers on issue?n Foxall We don’t need that much granularity, and what we have is fine – relative to the size of the market. The trade off for granularity is liquidity in individual lines: the more lines there are, the less liquidity in each one.n yencken From a sell-side perspective, since the AOFM came back to the market and started adding to transparency and liquidity we have noticed a substantial increase in offshore participation. This was missing in the past: there were opportunistic investors from offshore coming in and out of the market but it was not very liquid. There is now a significant amount of offshore enquiry with a number of different participants buying. This has made it much easier for us to match buyers and sellers.

SUPPLY IMPERATIVES

n nicholl The decision to come back into the linker market in 2009 accompanied a rapid increase in the AOFM’s issuance programme, and it was seen as a way of attracting a wider set of investors into the government securities market.

One thing we hear and understand is the importance of regular supply. To the extent that we can manage this we certainly treat it as a priority. We perceived a degree of softness in the market late in 2011, which caused us to slow down issuance to some extent. But that opened up the possibility later in the year of issuing a new line by syndication – which we believe was received well.

With regard to offshore issuance, the launch of the new bond – the 2022 – allowed us a window into the international market. Interest is still predominantly from domestic buyers, but we are seeing growing enquiry from offshore.

It is certainly important to use the supply we have available to develop the market and to ensure our lines are liquid. The feedback we receive is that liquidity is good for the size of the linker market. But we don’t take this for granted and we remain aware of the need to maintain and, where possible, build liquidity in order for the market to remain effective.

Given the market is relatively small compared with the nominal programme, and that it involves a strong representation of domestic investors, we have been able to consult with inflation investors more easily and frequently. We have found this to be useful and we will continue the dialogue.

davison what has the return of the aofm meant for the pre-existing inflation-linked issuance programme conducted by Tcorp?n hext Demand has picked up, which is good. It is still disappointing, from our perspective, that offshore demand largely defaults to the sovereign. I suspect this is a liquidity issue as much as anything. About half our nominal issuance is held offshore, and although we don’t receive precise numbers for the linkers it is fair to say the number is much less than this.

Japanese investors in particular tend not to buy TCorp linkers, even though that market is our largest international supporter in nominal format.

We have had some success with buy-and-hold funds offshore – ones that might need to sell but generally take a long-term view. That has been encouraging, especially given we only have A$5.2 billion on issue. But there is definitely a lot more upside.n harvey We have seen good support for linkers this year. In the semi space in particular there

has been much interest from offshore, as there is not a lot of spread product on offer globally. Most offshore investors seem fairly comfortable with liquidity and spread volatility.n nicholl The government had an opportunity, prior to its renewed commitment in last year’s budget, to decide that inflation-linked issuance was not worth actively maintaining and to walk away from its further development. Given that the very reason the AOFM re-entered the market was that it was seeking

“since The aofm came back To The markeT we have noTiced a subsTanTial increase in offshore parTicipaTion. ThaT was missing in The pasT: There were opporTunisTic invesTors from offshore coming in and ouT of The markeT buT iT was noT very liquid.”Matthew Yencken Deutsche Bank

ben alexander, ardea inv. mgt. kent Wilkes, Queensland inv. corp.

roundtable discussion

5 4 | k a n g a n e w s j u n e 2 0 1 2

McFadyen New Zealand is moving towards its own issuance programme. Will that help visibility of inflation-linked product in the Asia Pacific region?

everitt Definitely. If New Zealand is able to put NZ$2 billion (US$1.5 billion) a year into the inflation-linked space, it will continue to draw focused attention from offshore investors in particular. Adding that to the regular issuance in Australia reduces the chances of the global investor base turning away from the Australiasian region.

The steps made so far in terms of attracting that focus have been great, but it is important to continue with

the education process of our offshore investor base in inflation-linked product within Australia and New Zealand.

harvey Transparency and consistency in the market have clearly improved over the past two years. The inflation market even battled through periods last year during which other markets were effectively broken, and the feedback from offshore is that it is good to see that stability. This has assisted greatly in broadening the level of participation from offshore investors.

davison What is the potential for future inflation supply? Does TCorp have any dynamic within its client base driving more inflation-linked borrowing?

hext The A$5.2 billion (US$5.1 billion) we have outstanding is predominantly from our utility clients. But physical inflation-linked funding has been relatively expensive for us for some time now, so we get the majority of our inflation exposure in swap format. To be honest, we probably see that continuing until demand for our linkers increases.

We issued A$400 million of linkers in the past year, which in some sense is disappointing.

But we are not unhappy about it, because we have a lot more exposure via inflation swaps.

McFadyen What impact will there be on TCorp’s physical paper if the issuer decides to make a move away from supplying the product?

Mullen The advantage with TCorp is that it has consistently confirmed that it will issue into investor demand. If we have sporadic or lumpy demand we can take it to TCorp.

hext The reality is that our bonds are cheap because the flow of new money into the inflation sector has been low. If demand comes back into line with previous years, we would be more comfortable issuing because physical inflation bonds are still an important funding source.

We are happy to show commitment to the asset class through quarterly tenders, but the fact is that if demand is low and the paper becomes very cheap our issuance volumes will be low. Ultimately, we have to do what is best for our borrowing clients, and when a product is significantly out of line with other available funding options we will reduce issuance.

nicholl It’s different for the Australian Office of Financial Management because we only have one client, whose needs are very different. Inflation-linked issuance is almost a policy choice for us, directed by the federal treasurer. There is substantial scope and flexibility for us to develop the market over the next few years, which is what we intend to do.

alexander I think it is good for the market for an issuer like TCorp to have the option to give physical or derivative

PaThs To wider issuanceThe federal government and a single state borrower – New South Wales Treasury Corporation (TCorp) – are Australia’s only committed inflation-linked bond issuers. There are some potential sources of additional regional deal flow, but the best new supply prospects probably lie in the derivatives market.

exposure. Investors should have no problem using either, and having the opportunity to hold the best-priced asset can only be a good thing for the investor community.

davison While bank balance sheets are constrained, Australia still has a significant infrastructure funding task. Is there the possibility of more inflation-linked issuance from the infrastructure sector?

banbury It’s certainly the case that long-dated utility infrastructure assets have an inflation component to their revenues, so there is the capacity for derivative supply to come from that source. But there is a necessary process of educating treasurers and boards about the developments in the inflation market that will allow them to manage the real risks they face. For a long time inflation exposure has been ignored because the capacity to manage this risk was limited.

yencken The time when the market would accept ultra long-dated corporate risk with inflation attached to it has gone, I think. Investors want to separate their rates, credit and inflation risks and manage them separately – which they are right to do. Inflation risk can still come to the market from that sector, but it will more likely be in synthetic format.

tribe I have sympathy with that view. Infrastructure is more likely to result in inflation-linked swap supply rather than bond issuance.

“Physical inFlation-linked Funding has been relatively exPensive For us For soMe tiMe noW, so We get the MaJority oF our inFlation exPosure through the sWaP Market. to be honest, We Probably see that continuing until deMand For our linkers increases.”t i M h e x t n e w s o u T h w a l e s T r e a s u r y c o r P o r a T i o n

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to draw in a broader range of investors, the decision was made that it was worth maintaining a presence. Nevertheless, the reality is that further development will only happen gradually and over time.

McFadyen should inflation-linked product be a more prominent asset class in australia, especially given the ageing population?n hext We launched a retail annuity bond earlier in 2012 and the comparisons made in the newspapers were to term deposits. Even though it has a nine-year maturity it was being compared in yield to a three-month term deposit. There is a long way to go in the superannuation world before inflation-linked securities are commonly accepted.

The government can have a huge role here. If it can alert people to the risks they are running by having duration in equities, and discourage it, that would be a very good public policy initiative.n langer There is a misconception about fixed income overall and there is a view that long duration is often a bad thing. Duration as a concept is misunderstood and as an industry we need to explain better the value of low-credit-risk investments. Having long-dated assets is not necessarily a bad thing, as the pull-to-par effect and re-investment of income on a portfolio of bonds recovers losses from higher yields relatively quickly – especially compared with equities.

As we have heard, from a 10-year perspective inflation is relatively predictable due to central bank mandates. What you worry about is what might happen in the next 20 or 30 years, and that is why you want long-dated linkers as protection against unexpected changes in inflation.n Pelosi Linkers should come to the forefront of our thinking when we consider the ageing of the population. Most importantly, investors can protect their purchasing power without needing to take excessive rate risk.

The argument that long duration sits more naturally in this asset class due to a notion that inflation uncertainty rises with term is not supported by the data. In fact, it is

quite the opposite: longer-term inflation expectations are less volatile further out on the term structure, while greater uncertainty typically exists around inflation expectations in the zero to 10-year part of the curve. This suggests to me that longer-term inflation expectations are better anchored and that insurance against inflation shocks is best sought over medium-term horizons.n alexander Population demographics are relatively easy to predict and it is quite clear that Australia, like the developed world in general, is ageing. We would like to see post-retirement products from the superannuation community.

Many superannuation funds have a CPI-plus objective, but very few do anything specific to address the CPI part of that. In the post-retirement product world this will have to be taken more seriously, with inflation-linked bonds playing an important role. Australia is not unusual in this respect. If

you look overseas, there are developed economies with good inflation-linked bond markets and where people don’t just invest in equities as their means of achieving investment return. I expect the current group of superannuants, who have had a bad experience, will look for something different in future.n Mullen Yes, but part of the problem has been a lack of education about inflation-linked bonds. To get to a stage where we could put one of our inflation-linked products on the retail platform, we had to progressively educate our investment professionals, platform providers and distributors. Even that is presupposing that the average 65-year-old Australian will ask their adviser about inflation-linked bonds – when in most cases they don’t even know what one is!

We keep asking investors to make informed investment decisions, but we need to provide them with the relevant information to do so. I think we

underestimate how difficult this is to do. We are a long way from having inflation-linked bonds become a core part of the superannuation industry. n banbury That’s an important point. We are two years into what has been an important evolution for this market, but there is still a long way to go. Annette Mullen’s comments about superannuation investors are also true for the corporate sector: for most corporates inflation remains a non-vanilla product. •

“we currenTly assign a reasonably low probabiliTy To The Japanese-sTyle ouTcome and a somewhaT higher probabiliTy To The inflaTionary ouTcome. buT we Think This is mosT likely To occur via sTealTh raTher Than Through an expliciT change To cenTral bank mandaTes.”kent wilkes QueenslanD investMent corporation

“iT could be hard To avoid an inflaTionary response in The long Term. however, in The shorT Term i don’T Think There is inflaTion risk aT all, aside from The carbon Tax’s impacT and oTher one-off evenTs.”Julian Foxall piMco