HSBC launches Hong KongÆs first inflation-linked bond fund

Halfway through the launch of its Emerging Markets Inflation-Linked Bond Fund, HSBC's regional chief economist Peter Morgan says, with a grin, that Indonesia has just announced its May inflation figures and the consumer price index has risen by 10.38%.

Indonesia's latest annual inflation figure is its highest in 20 months, leading to expectations of a second interest rate increase in that market this year. As is the case in most of Asia, higher food and fuel prices were mainly responsible for IndonesiaÆs rising inflation. Newly appointed Bank Indonesia governor Boediono believes inflationary pressures are still strong and the consumer price index could rise to between 11.5% and 12.5% by the end of the year.

Elsewhere in Asia, May inflation hit a seven-year high in South Korea and a 10-year high in Thailand as the region fights to stave off this single biggest threat to economic expansion at the moment.

So why is HSBCÆs Morgan cheering on the news about IndonesiaÆs double-digit inflation? Because in the context of HSBC Global Asset ManagementÆs latest fund, rising inflation is good news.

ôIf you canÆt beat them, join them,ö says Patrice Conxicoeur, CEO of Sinopia Asset Management Asia-Pacific, which is the quantitative investment arm of HSBC Global Asset Management. ôOur fund offers investors a chance to benefit from inflation, not suffer from it.ö

HSBCÆs latest offering is the first inflation-linked bond fund in Hong Kong, and Conxicoeur believes it may be the first one in the world. The fund will be managed by Sinopia.

The fund aims to provide capital growth and quarterly dividend payouts by investing primarily in inflation-linked bonds issued by the governments and quasi-governments of emerging markets. Those bonds are a natural hedge against inflation.

In traditional bond funds, issuers of the underlying bond assets repay the principal amount upon maturity. While the principal is intact, the value of the principal after years of being held in the fund may be eroded by inflation. Normally, inflation is the enemy of a bond investor.

In an inflation-linked bond fund, the underlying assets have the principal indexed to inflation. The higher the inflation, the higher the principal and coupon payment.

Using inflation as an investment theme plays well on the growing fears of higher consumer prices in emerging markets. ôInflation is a reality,ö says Conxicoeur. ôIt is hitting everybody.ö

Global food prices have risen 83% over the past three years. Corn and wheat prices have doubled over the same period, and rice in 20% more expensive and is even being rationed is certain markets to avert a crisis. Oil prices, meanwhile, have doubled over the past 12 months. Two weeks ago, they hit a record high of $135.09 a barrel on the futures market.

Central banks in Asia have been fighting inflation either by raising interest rates or allowing their currencies to appreciate. Higher interest rates tend to reduce demand, but have the side-effect of pushing currencies higher. Allowing currencies to appreciate reduces the value of imports.

ôPolicy implication depends on where inflation is coming from,ö says Morgan. ôOur view is there is a demand component to this and that contributes to inflationary pressures.ö

HSBC expects emerging market economies to continue to expand even if the US economy is in bad shape. But with this growth will come inflationary pressures.

HSBCÆs latest fund will start investing on June 23. As of now, the model portfolio for the fund shows an allocation of 32% of the assets to inflation-linked bonds issued by Mexico, 25% by Brazil, 14% by South Africa, 11% by Turkey, 7% by Chile, 5% by Colombia, 4% by Poland, and 2% by South Korea.

The fund will invest only in inflation-linked bonds with a minimum B rating; its model portfolio is made up mostly of BBB-, A-, and AA- rated bonds, with an average portfolio credit rating of investment grade.

The fund will have a maximum country weighting of 35%, volatility of 8% to 10%, and an expected yield of 7% to 9% annually.

Argentina, which carries a 20% weighting in the widely used Barclays Capital Emerging Markets Government Inflation-Linked Bond Constraint Index, is noticeably missing from HSBCÆs model portfolio and thatÆs because its managers pay special attention to inflation and real interest rates.

Conxicoeur says the fund is an opportunity for investors to gain access to a market that is fairly young, making up only a small corner of the overall bond market. The US is the largest inflation-linked bond market in the world and in emerging markets such as Turkey and South Korea, such instruments were introduced only last year.

The fund is now available to Hong Kong retail investors, but will also be made available to private banking and institutional clients in Singapore and Europe. Conxicoeur hopes to raise at least $30 million to $50 million from the Hong Kong offering of the fund, which would be the minimum amount needed to make the portfolio viable.

Apart from the inflation hedge, the fund also provides diversification, low correlation to traditional asset classes, and a potentially better risk/return profile, Conxicoeur says.

Risk factors include the overall direction of consumer prices and interest rates, as well as currency fluctuation. To mitigate the risks, the fund makes use of tactical hedging of highly volatile and overvalued currencies.

The probability of inflation slowing down or even turning around to give way to deflation is a risk that Conxicoeur acknowledges, although he believes a sudden change in the consumer price scenario is remote. Inflation does not fluctuate as quickly as interest rate or currencies, he says. Besides, the fundÆs managers will respond by adjusting the portfolio to prevailing circumstances, such as reducing holdings in markets where inflation is easing and increasing holdings in markets where inflation trends are rising.