Sunday, April 23, 2006

Why isn't there more index-linked debt around?

A Martian with some grasp of finance theory venturing into the City of London would be amazed that there are not more borrowers coming forward to take advantage of the unprecedented low long-term real sterling interest rates. The British authorities (the Debt Management Office and the Treasury) may have decided that inaction speaks louder than words, but they are not the only potential players.

Why are there no other sovereign borrowers issuing long-term sterling linkers? Does the real exchange rate risk deter them? Unlikely, because most sovereign borrowers (and their advisers) don't know what real exchange rate risk is. Why do the multilateral development banks and international financial institutions - the World Bank Group, the European Bank for Reconstruction and Development, the Inter-American Development Bank, the Asian Development Bank and the European Investment Bank among them - not issue long-term index-linked sterling debt? Their credit rating matches that of the highest-rated sovereigns.

If the profit motive is too anemic in these publicly-owned institutions, why are there no private financial innovators entering the market? I would love to refinance my (nominal) variable rate Sterling repayment mortgage with a long-term index-linked mortgage, but it is slim pickings in the sterling index-linked repayment mortgage market. During the 19 years I lived in the US, I just received blank looks from my bankers when I asked about index-linked mortgages. Here in the UK, I am told they (the banks) don't offer them because they have never offered them.

And where are the private financial engineers? Leading private financial corporations and non-financial corporates can issue long-term index-linked debt. While such private debt instruments would not have the AAA rating that the markets appear to crave, they could be used to back the issuance of Collateralised Bond Obligations. The senior tranche of such CBOs could well have the AAA rating that is so sought after these days. The subordinated tranches could become the first long-term index-linked junk bonds; inflation-proof junk may well be an instrument whose time has come.

It is of course possible that willing borrowers are absent because would-be borrowers believe that today'’s low real long-run rates will be followed by even lower rates tomorrow. It is possible for real interest rates to be negative, unlike nominal interest rates, but I doubt whether many of the absent borrowers really believe that a time will come when the 0.46% real interest rate on 50-year index-linked gilts we saw in January 2006, will be viewed as a high real rate.

I have to conclude that while financial markets may well be efficient, they sure are slow. Financial innovation occurs with amazing speed when it comes to the design of complex designer derivatives whose properties not even their creators understand and that may well have negligible, or even negative, social value added. When it comes to rather simple index-linked debt instruments that might actually do some good, hide-bound conservatism seems to rule the roost and nothing happens.

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