Reign of inflation-linked bonds likely to continue
Reign of inflation-linked bonds likely to continue
Bonds linked to inflation, known as Treasury Inflation-Protected Securities (TIPS), will likely deliver less impressive returns in 2013 with their yields stuck in negative territory, but big bond investors say don’t bet against them yet because of the Federal Reserve.
TIPS are on track to beat Treasuries for a fourth straight year, the longest such streak since 2001 to 2005. In the past three years, TIPS managed an average annual return of 10.4 percent, surpassing the 4.0 percent average return on regular Treasuries, according to Barclays.
“It’s going to be a struggle to repeat the performances we have seen the last three years, but I still see tremendous value in owning TIPS as opposed to other fixed income assets because all rates are low,” said Martin Hegarty, co-head of BlackRock’s inflation-linked bond portfolios in New York.
The US central bank, led by Chairman Ben Bernanke, has been pumping cash into bonds in a bid to reduce high unemployment and boost economic demand.
It has bought billions in bonds each month since late 2008, causing its balance sheet to balloon to $ 2.86 trillion. Because of that, virtually all US interest rates are hovering at historic lows.
“They have drawn long-term interest rates lower and they will hold them there until there’s a sustained growth trajectory,” said Gemma Wright-Casparius at Vanguard in Malvern, Pennsylvania, who runs the $ 44.8 billion Vanguard Inflation-Protected Fund, the biggest US TIPS mutual fund.
The Fed is widely expected to decide to continue its bond purchases at its policy meeting next week.
The Fed’s bond buying has elevated prices of oil, food and other commodities. This has generated enough inflation to allow TIPS — whose principal and interest payments adjust against the US Consumer Price Index — to outpace Treasuries and most other US bonds since 2008.
With TIPS, most of their yields, dubbed “real” yields, have been treading in negative territory, which makes them pricey.
The “real” yields on a 10-year TIPS typically match the expectations for long-term US economic growth, which had averaged 3.5 percent to 4.0 percent before the Great Recession.
But the sluggish growth rate during the current recovery and the Fed’s quantitative easing have skewed the 10-year TIPS yield, so it does not reflect traders’ US growth outlook.
So how have TIPS, with their negative yields, managed to generate higher returns than most other US debt with the exception of corporate bonds?
Thank the Fed for propping up inflation expectations.
Investors use so-called breakeven rates to express their inflation view. Breakeven rates represent the gap between the “real” yields on TIPS and the yields on regular Treasuries.
On Thursday, 10-year inflation expectations stood at 2.46 percent, higher than the year-over-year inflation rate of 2.2 percent in October. With the Fed buying a tremendous amount of government bonds, it has boosted expectations for future inflation.
As long as the CPI remains positive, the government will provide positive adjustments on principal and interest payments on TIPS, boosting their overall returns.
How much inflation adjustments will enhance TIPS returns going forward is impossible to predict with certainty, but it is estimated that at least a third of their future return will be tied to CPI adjustments.
Even though the TIPS sector has become pricey, the longest TIPS maturities still have potential for their yields to fall further. Fund managers say investors have not fully priced in the inflation risk from the easy monetary policies that the Fed and other major central banks have pursued.
“If real yields go lower, the 30-year will lead the charge because there is a significant grab for duration,” BlackRock’s Hegarty said.
The 30-year TIPS breakeven rate is 2.47 percent, essentially the same as the 10-year TIPS rate, suggesting traders are not demanding additional inflation premiums for another 20 years.
Buying “30-year breakevens make a lot of sense. There should be more of a risk premium out given how accommodative Fed and global monetary policy is,” said Bill Irving, a portfolio manager with Fidelity Investments in Merrimack, New Hampshire, who oversees about $45 billion in bonds.
While TIPS fund managers interviewed were confident TIPS will continue to beat Treasuries next year, they were less so about the overall return of TIPS.
“I won’t say it’s the end of the run for TIPS. I think there is still a decent potential to outperform Treasuries, but I think both of them have the risk of posting negative returns,” Fidelity’s Irving said.
If US growth and inflation were to accelerate due to say an orderly resolution of the “fiscal cliff” dispute over the federal budget, all bonds including TIPS could become less appealing as investors look to stocks and other growth-oriented investments.
Rather than owning a traditional TIPS fund, investors might consider other bond alternatives. AllianceBernstein offers a “TIPS-plus” portfolio that is a mix of TIPS, corporate and other types of bonds. This strategy offers inflation protection but reduces the interest-rate risk on TIPS if yields spike higher.
Another approach to reduce interest-rate risk on TIPS is beef up on short-dated issues. While shorter-maturity TIPS promise lower returns, their value erodes less as yields rise.
After MSCI upgrade, Tadawul chief turns to the next challenge for Saudi Arabia
DUBAI: Khalid Al-Hussan seemed to be enjoying himself last Thursday at the Riyadh headquarters of Tadawul, the Saudi Arabia stock exchange, of which he is chief executive. In fact, a quiet smile of satisfaction rarely left his face, even under the bright glare of the television lights of the international media.
“We’ve all worked very hard and we’re very pleased,” he told Arab News once the TV cameras had left, adding that it had been “one of the best days” of his professional career.
Al-Hussan had just left the podium of a press conference — shared with Tadawul chairperson Sarah Al-Suhaimi and the chairman of the Capital Markets Authority, Mohammed Al-Kuwaiz — to announce the fact that, after three years of preparation, Saudi Arabia had finally been included in MSCI’s Emerging Markets index.
It was actually more of a celebration than an announcement. MSCI had broken the news some hours earlier that Saudi Arabia was to be classed as an emerging market (EM), rather than a frontier market, putting the Kingdom on the radar of international investors in a big way. All three of the market dignitaries were in effusive mood, gratefully accepting multiple “mabrouks” from the media pack.
The move by MSCI, it is estimated, will pull in as much as $45 billion in foreign investment to the Saudi exchange; that figure could rise sharply if the Saudi Aramco listing goes ahead on the bourse. That is a huge boost for a market with a current market capitalization of about $520 billion.
It has already been quite a year for the Tadawul chief, with a lot of the hard work of his previous three years in the job paying off handsomely. In March, another international index compiler, FTSE Russell, had also upgraded Saudi to emerging market status, and there have been launches and bolt-ons of other services essential for a modern stock market, such as a central clearing system.
Perhaps most importantly of all, the Tadawul has been one of the best-performing markets in the world in 2018, with a 13 percent rise in the first six months. “It has been one of the best years, rather than just a good day today,” Al-Hussan said.
“MSCI inclusion is a reflection of how our reforms have been widely accepted, by local and international markets. It was designed as a plan to achieve what we have today,” he added.
The Riyadh exchange has always been the biggest in the Arabian Gulf region, but since 2015 it has been transformed into one of the most modern and efficient too.
New, internationally recognized settlement systems have been introduced, governance systems upgraded, and foreign investors welcomed. The status upgrades by global investing organizations — there is another due from S&P before the end of the year — are the logical end of all this work.
It has not been without its challenges, Al-Hussan remarked. “To balance the needs of international and local investors was sometimes a challenge, especially in the move to new settlements systems. But if you understand the market, and know where you’re trying to get to, it’s possible to get both of them working together,” he said.
There is another challenge, which in some ways the MSCI upgrade is designed to overcome: the nature of share trading and stock markets within the broader economic context of Saudi Arabia and the Arabian Gulf. It is an issue of the perception of the region in the world as much as anything else.
While analysts generally welcomed news of the MSCI upgrade, some delivered the opinion that inclusion in international indices was not in itself so significant for regional markets, and the Saudi market in particular.
Other factors ultimately determined the health and appeal of Gulf markets, the theory went, in a part of the world where the oil price is the single most important economic factor, and regional geopolitical events color global investors’ overall views. Foreign confidence in Saudi Arabia was also hesitant, given the sheer pace of the change going on in the Kingdom under the Vision 2030 strategy, it had been argued.
It is a line Al-Hussan has heard before, and he has a ready answer. “I disagree that MSCI inclusion is less important than these other factors. It is a sign of the confidence of international investors in the Saudi market, and a reflection of how confident they feel here,” he said.
“The new cash that we can expect from international investors — around $40 billion — is not small or insignificant, and these people will not take risks lightly. The people at MSCI are pretty intelligent too. They have never moved a country from the watchlist to full EM status so fast — in just 12 months — so that tells you about their confidence, and the confidence of their clients, in Saudi Arabia,” he added.
And, finally, there is the clinching argument that non-market factors can always have a profound effect on financial markets, and not just in Saudi Arabia or the Gulf countries. “Economic and geopolitical factors could have an effect on markets anywhere in the world, not just here,” he said.
An engineer by training, Al-Hussan was educated in the US to MBA standard, and qualified as a certified entrepreneur from the University of Colorado. His previous career in the insurance industry made him aware of the need to weigh risk; 10 years at Tadawul — working across virtually all its functions from business development to strategy and operations before becoming CEO — has seen him apply those lessons in the context of financial markets.
There is a lot more to do, Al-Hussan insisted. “Our plans never end. I’m more excited about what’s to come as we continue to enhance the market’s future” he said, before outlining the strategy to launch a full national clearing system that would enable Tadawul to launch derivatives trading platforms by the end of 2020 in a staged process.
There is also the plan to enhance the market-making function, so that traders can operate to international best practice standards by the end of this year. “There is already a model in place, but it will be perfected to global standards by the end of the year,” he said, rejecting suggestions that the innovations at the Tadawul might encourage the inflow of speculative “hot money” into the Kingdom.
All this reform and improvement is desirable in itself, of course, and for the good of the Kingdom’s financial markets. But there is a big goal in sight that Al-Hussan and Tadawul are aware they must keep in focus: the historic initial public offering of Saudi Aramco, as well as the other multibillion-dollar privatizations that are planned under the Vision 2030 plan.
“Of course, there is Aramco,” he said as he contemplated the list of tasks ahead. The IPO of the biggest oil company in the world is the centerpiece of the Kingdom’s plans to transform its economy away from oil dependency, and Tadawul has been designated the “home market” for the IPO.
The biggest stock exchanges in the world — New York, London, Hong Kong — have all been mentioned as possible venues for Aramco, but it is certain that Tadawul will also play a big part in the sell-off.
Al-Hussan caused quite a stir at last year’s Future Investment Initiative in Riyadh when he declared his “aspiration” to stage the IPO exclusively on Tadawul. He has since repeated his confidence that the Saudi exchange could handle the whole issue, which could be worth as much as $100 billion.
“Of course, I would like to have all of it, but that is a decision for Aramco and for its shareholder, the government. We will support whatever decision they reach,” he said. He also confirmed that Aramco would not have to wait until the MSCI upgrade — coming into force in two stages from May of next of year — is fully implemented. “We will be ready for it as soon as the decision on the IPO is made,” he said.
If the government did decide to put the whole of the Aramco IPO on Tadawul, it would change the character of the exchange completely, and alter MSCI’s calculations significantly.
MSCI awarded Tadawul a weighting of 2.6 percent of its global EM market, but that would increase enormously if Aramco were included. Al-Hussan agreed it could double the amount of funds flowing into the Saudi Arabian market.
It could also tie the fortunes of the Tadawul to the global oil industry in a way it is not now, by making it dominated by the biggest energy company in the world. Part of his philosophy has been to make the Tadawul — where banks and heavy industrial companies play a dominant role — more attractive to other sectors and more reflective of the changing national economy.
“We still aspire to do it. It would be a challenge, of course, but I think over the past three years, and with the upgrades, we’ve shown that we meet challenges,” he said.