Corporate linkers could provide investors with an attractive inflation hedge

First published in Investment Week

Inflation is a major concern today and investors face an uncertain trajectory, especially bond investors.

In light of this, corporate inflation-linked bonds (‘linkers’) look well-positioned to mitigate the risks posed by inflation to a bond’s rate of return.

Corporate linkers work like their more established counterpart – government inflation-linked bonds. These instruments are designed to remove the uncertainty caused by inflation, so they provide investors with a known real rate of return. Essentially investors in linkers will receive actual inflation as opposed to expected inflation. Corporate linkers, however, will offer an additional premium, in order to compensate investors for the credit risk of the company. In this regard, are they an attractive investment?

Interestingly, many people believe that when you buy linkers you will get a return in line with inflation. That is not true. When you buy a linker you actually receive a real rate of return, so inflation is only one part of the equation. It is important to understand also where the real rate is. Suppose you buy a linker and you hold it until maturity. If your real yield is 0%, then you will get whatever inflation was over the period, however if the real yield is negative, you are guaranteeing yourself a negative real return.

Unlike government bond linkers, many corporate linkers are now trading with a positive real rate, thanks to the additional compensation they receive from spreads. This means they are in a better place to deliver return in line or greater than inflation.

Whereas government linkers have a history dating back to the early 1980s, the market for corporate linkers remains niche. The biggest market in Europe is the UK, with roughly £30bn of amount outstanding. Eurozone countries do not generally have many companies issuing linkers, perhaps reflecting the very low inflationary environment they had over the last few years.

Most of the companies issuing linkers, particularly in the UK, are utilities. For example, National Grid, Thames Water and United Utilities. Example of non-utilities are Heathrow or British Telecom. Outside the UK we can find names such as Enel, Terna and some financials that issue in this space.

It is mainly utility companies because they tend to have revenues more directly linked to inflation. So, for them linkers can be a natural hedge. As inflation rises, the amount they have to pay on linkers will growth, but their revenues will grow too. Vice versa, if inflation falls, their revenues will decline and so will the amount to pay on linkers.

There are a couple of reasons why corporates might find it attractive to issue linkers. The first one is clearly to broaden their investor base. The second one is that if revenues grow in line with inflation (typically the case), then issuing some inflation-linked debt can be a natural hedge. So, if inflation rises 2%, then it is true that the company will have to pay more on these instruments, but it is also true that the company will see an increase in revenues to compensate for that. Again, if inflation falls, revenue will decrease, but so will the cost of debt.

We believe there will be more demand for inflation instruments going forward and this should benefit the corporate linker market too. We have been through a long period of very low and stable inflation and investors did not pay much attention to this market. However, things have changed. Investors have now experienced inflation and this may push them to rethink how they want to allocate money going forward. And inflation instruments, with the potential to deliver a positive real yield, will likely be at the top of their list.