Infla tion-indexed Securities

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Infla tion-indexed Securities

Bonds, Swaps and Other Derivatives

Second Edition

Mark Deacon

Andrew Derry

and

Dariush Mirfendereski

John Wiley

&

Sons,

Ltd

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2.1.2 Index reliability and integrity 2.1.3 Other practical considerations 2.2.1 Capital Indexed Bond (CIB) 2.2.2 Interest Indexed Bond (IIB) 2.2.3 Current Pay Bond (CPB) 2.2.4 Indexed Annuity Bond (IAB) 2.2.5 Indexed Zero-Coupon Bond (IZCB) 2.2.6 Other types of indexed bonds 2.2.7 Cash flows of the different structures

2.2.8 Factors that influence the choice of security design 2.2 Cash flow structure

xii xiii xvii xix xxi xxiii xxv xxvii xxix 9 9 9 11 16 17 18 18 19 21 22 23 23 24

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2.3

2.4

2.5

2.6

2.7

Application of the index to the cash flows 2.3.1

2.3.2 2.3.3

2.3.4 Full or partial indexation? The impact of tax regulations 2.4.1

2.4.2

Options on indexed bonds 2.5.1 Callable bonds 2.5.2 Puttable bonds 2.5.3 Convertible bonds Method of issue 2.6.1 Pricing 2.6.2

2.6.3 Consistency with other instruments 2.6.4 What happens in practice?

Summary

The problem of the indexation lag Why indexation lags are necessary How to minimise the indexation lag

Uncertainty of post-tax real yields The effect of income accrual rules

Cost -effectiveness and market development

Appendices A2.1 A2.2

Calculating the base annuity payment for Indexed Annuity Bonds (IABs)

Barro’s proposal for revising the inflation adjustment of payments on index-linked gilts

3 Why Invest in Indexed Debt? 3.1 Reducing inflation risk 3.2 Relative stability of returns 3.3

3.4 Total return opportunities 3.5

3.6 Taxation 3.7 Liquidity

3.8 Other potential deterrents to investing in indexed bonds 3.9 Alternatives to indexed bonds

3.9.1 Treasury bills 3.9.2 Equities 3.9.3 Property

Performance relative to conventional bonds and equities Duration and other cash flow considerations

3.10 Summary

4 Why Issue Indexed Bonds?

Why governments issue indexed bonds

4.1.1 Reducing borrowing costs: the role of inflation expect ations

4.1.2 Reducing borrowing costs: saving the inflation risk premium 4.1.3 Risk management 4.1 26 26 27 28 29 31 31 33 34 34 34 35 35 36 37 37 38 38 39 39 40 43 43 44 46 49 51 52 53 55 55 55 56 58 58 59 59 59 61 64

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Contents vii 4.1.4

4.1.5

Why private corporations issue indexed bonds The relative scarcity of index-linked bonds

Inflation-indexed bonds and monetary policy Maintaining long-term capital markets in difficult economic conditions

4.2 4.3

4.4 Summary

5 Inflation and Real Interest Rate Analysis 5.1

5.2

5.3

5.4

Measures of real interest rates 5.1.1 Real gross redemption yields 5.1.2

5.1.3

Measures of inflation expectations 5.2.1 Break-even inflation rates 5.2.2 The “inflation term structure” 5.2.3

Hedge ratios: the duration and “beta” of inflation-indexed bonds

The term structure of real interest rates

The inflation risk premium and bond con rex t Y Analysis of real interest rates and inflation expectations 5.3.1 Real interest rates

5.3.2 Measures of inflation expectations Summary

6 Major International Indexed Bond Markets 6.1 6.2 6.3 6.4 6.5 6.6 Australia 6.1.1 6.1.2 Canada France 6.3.1 6.3.2 6.3.3 Sweden 6.4.1 6.4.2 6.4.3 Recent developments United Kingdom

6.5.1 A brief history of the index-linked gilt market 6.5.2 The structure of the index-linked gilt market

6.5.3 The market for non-government index-linked bonds in the UK

United States of America

6.6.1 A brief history of indexation in the USA A brief history of indexation in Australia

The structure of the Commonwealth Treasury Indexed Bond (TIB) market

The history of indexation in France

The introduction of inflation-indexed OATS (Obligations assimilables du Tresor)

Indexation to pan-European inflation - OAT€i bonds

The formation of the Swedish government index-linked bond market

The development of the market toward international standards 65 66 66 67 71 73 74 75 77 79 80 81 82 83 85 85 89 92 93 94 94 99 100 106 106 107 113 119 119 120 124 128 128 136 138 141 141

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6.6.2 6.6.3 6.6.4

The launch of the Treasury Inflation-Indexed Securities (TIIS) market

The expansion of the TIIS programme in the fiscal surplus years

Recent developments in the market for inflation-indexed securities in the USA

Appendices

A6.1 Cash flow calculations for Australian Capital Indexed Bonds (CIBs)

A6.1.1 Calculation of interest payments A6.1.2 Calculation of the settlement price

Cash flow calculations for Canadian Real Return Bonds (RRBs) A6.2.1 Indexing process

A6.2.2 Calculation of interest payments A6.2.3 Calculation of the redemption payment A6.2.4 Calculation of the settlement price

Cash flow calculations for French OATi and OAT€i bonds A6.3.1 Indexing process

A6.3.2 Calculation of interest payments A6.3.3 Calculation of the redemption payment A6.3.4 Calculation of the settlement price

Cash flow calculations for Swedish index-linked Treasury bonds A6.4.1 Indexing process

A6.4.2 Calculation of interest payments (for coupon-bearing bonds)

A6.4.3 Calculation of the redemption payment A6.4.4 Calculation of the settlement price

Cash flow calculations for UK Index-linked Gilts (IGs) A6.5.1 Indexing process

A6.5.2 Calculation of interest payments A6.5.3 Calculation of the redemption payment A6.5.4 Calculation of accrued interest

A6.5.5 Calculation of real yields

Cash flow calculations for US Treasury Inflation-Indexed Securities (TIIS)

A6.6.1 Indexing process

A6.6.2 Calculation of interest payments A6.6.3 Calculation of the redemption payment A6.6.4 Calculation of the settlement price A6.2

A6.3

A6.4

A6.5

A6.6

7 Other Indexed Bond Markets 7.1 Argentina 7.2 Austria 7.3 Bolivia 142 148 151 160 160 160 161 162 162 163 163 163 165 165 167 167 167 168 168 169 169 169 171 171 171 172 173 174 176 176 177 177 177 179 180 182 182

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Contents ix

7.4 Brazil 182

1964-1 986 Readjustable National Treasury Obligations

(ORTNs) 182

1986-today National Treasury Obligations (OTNs), Treasury Bonds (BTNs) and National Treasury Notes

(NTNs) 184 7.5 Chile 186 7.6 Colombia 188 7.7 Czech Republic 189 7.8 Denmark 191 7.9 Finland 193 7.10 Germany 194 7.11 Greece 194 7.12 Hungary 195 7.13 Iceland 198 7.4.1 7.4.2 7.14 India 20 1 7.15 Ireland 20 1 7.16 Israel 202 7.19 Kazakhstan 210 7.20 Mexico 210 7.21 Netherlands 212 7.22 New Zealand 212 7.17 Italy 207 7.18 Japan 209 7.23 Norway 215 7.24 Peru 216 7.25 Poland 216 7.26 Portugal 219 7.27 South Africa 219 7.28 Spain 224 7.29 Switzerland 225 7.30 Turkey 225 Appendices

A7.1 Calculation of the settlement price for Colombian TES-UVR bonds

A7.1.1

A7.1.2 Price calculation example

Calculation of the settlement price for Icelandic Treasury Bonds A7.2.1 Indexing process

A7.2.2 Calculation of the settlement price A7.2.3 Price calculation example

Calculation of real yields for Israeli inflation-indexed bonds A7.3.1 Sagi and Galil bonds

A7.3.2 Kfir bonds

Calculation of the settlement price A7.2 A7.3 227 227 227 228 228 229 229 230 230 230

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A7.4 Cash flow calculations for New Zealand Treasury inflation-indexed bonds

A7.4.1 Calculation of interest payments A7.4.2 Calculation of the settlement price A7.5 Exchange rates

8 Inflation-linked Derivatives: Market Description 8.1 8.2 8.3 8.4 8.5 8.6 Overview 8.1.1 Introduction

8.1.2 Why Inflation-linked (IL) derivatives? 8.1.3

A brief history of Inflation-linked derivatives markets 8.2.1 Early history

8.2.2 The UK market 8.2.3

8.2.4 The Swedish market 8.2.5 Non-European markets Inflation payers (issuers)

8.3.1 Standard derivative solutions for Inflation-linked (IL) issuers

8.3.2 Private Finance Initiative (PFI) projects in the UK 8.3.3 UK housing associations

8.3.4 Swap structures to mitigate credit exposure Inflation receivers (investors)

8.4.1 The use of inflation swaps to hedge pension liabilities 8.4.2 Inflation-guaranteed and Inflation-linked (IL) retail

products Inflation options

8.5.1 Options embedded in bonds

8.5.2 Standalone inflation options in the Over The Counter (OTC) market

Future trends

8.6.1 Market standardisation 8.6.2 Pension reforms in Europe 8.6.3

8.6.4

The Inflation-linked (IL) derivatives markets in 2003

The French and Euro-zone markets

The implications of changes to accounting standards Further development of the inflation derivatives markets Appendix

A8.1 Example swap and option structures

A8.1.1 Capital Indexed Bond (CIB)-style swaps A8.1.2 Real annuity swaps

A8.1.3 Interest Indexed Bond (1IB)-style swaps A8.1.4 Standard inter-dealer broker market structures

9 Inflation-linked Derivatives: Pricing, Hedging and Other Technical Aspects 9.1 Outline

9.2 Pricing approaches

9.2.1 What is meant by “pricing”?

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Contents xi 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.1 1

9.2.2 Four levels of pricing 9.2.3 Level I

9.2.4 Level I1 9.2.5 Level 111 9.2.6 Level IV

Deriving a forward Consumer Price Index (CPI) curve for Level I1 and I11 markets

9.3.1 Piecewise linear continuous function in CPI space 9.3.2 Piecewise linear continuous function in inflation space “Level I” markets in Europe: intraregional Euro-zone inflation spreads

Alternative approaches to the construction of inflation curves Asset swaps - connecting swap and bond prices

Hedging a swapped new issue 9.7.1 A simple “interim” hedge 9.7.2 A more precise hedge 9.7.3

The evolution of the Euro-zone HICP swap market 9.8.1

Historical estimation of price index volatilities Pricing inflation options

9.10.1 Zero percent zero-coupon floors 9.10.2 Year-on-year inflation floors Summary

A portfolio hedge for net outright inflation risk

Seven lessons from seven months of Euro-zone inflation swap data 10 Conclusion References Bibliography Useful websi t es Index 27 1 27 1 27 1 27 1 272 272 273 274 275 277 279 28 1 282 283 284 28 5 286 288 292 293 293 295 297 301 315 317 319