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When financiers working in derivatives gathered recently in Vienna for their annual conference, some were in an unexpectedly upbeat mood.
For while the market turmoil of the past year has destroyed much of the structured credit business, banks and hedge funds have identified a potentially fertile new field: the fear of inflation.
While soaring prices for oil and other products might seem like bad news to many policymakers, investors and issuers, for some bankers this trend is - perversely - almost welcome. That is because rising inflation concerns are leading to a surge of interest in the sector of finance that provides investors with protection against price swings or allows them place bets on those trends.
"The story right now is very simple - inflation is back," Domenico Azzolini, head of interest rate trading strategy at Barclays Capital, told the Vienna bankers and lawyers. "In the US we are seeing inflation trends we have not seen since 1991 and even in Japan we are seeing levels not seen since 1993. That creates interest in the inflation market - pension funds and insurance groups are key drivers now."
This trend is being amplified by another factor: a demographic watershed. With the baby-boomer generation entering retirement, there is a recognition among bond funds that providing a steady income stream for this vast new army of pensioners will require investment strategies with an inflation component.
Pimco, the biggest global institutional fixed-income investor with $800 billion in assets under management, recently unveiled a series of "real retirement funds" which seek to counter the ravages of inflation. The five funds have target retirement dates of 2010 to 2050 and focus on real assets that are expected to perform well in an inflationary environment.
"Inflation has not been an issue for 401K [pension] plans until now," says Stacy Schaus, the defined contribution practice leader at Pimco. "We are helping individuals meet their retirement goals and not have their future purchasing power eroded."
Pimco identifies Treasury Inflation Protected Securities (Tips), commodities and total return swaps linked to an index of property investment trusts as offering good protection.
Tips are linked to the consumer price index and pay out a higher premium as inflation rises, while commodities and property have traditionally prospered during infationary periods as investors seek real assets rather than holding equities, bonds or cash, whose value is eroded by rising prices. Since the start of 2007, the Reuters-Jefferies commodity index has risen 60 per cent.
Consensus
Such assets could disappoint if the weakening economy ultimately damps inflation. Leo Grohowski, chief investment officer at BNY Mellon Wealth Management, believes fears over inflation have led to overpricing. "Tips as an asset class do not look attractive unless you really are an inflation bear," he says.
Yet the consensus at Vienna was that the inflation derivatives market is poised for strong growth. One sign of this is a sharp rise in the level of trading in total return inflation swaps, which pay out a fixed sum linked to an inflation measure over time.
Also gaining in popularity are inflation caps: for a premium paid in advance, the owner receives a payout should inflation rise above a certain level during the life of the contract.
Derivatives products that enable investors and issuers to protect themselves from price swings, such as index-linked bonds or forms of inflation-linked derivatives, have existed in the capital markets for several decades.
Indeed, the very first set of over-the-counter derivatives, invented in the late 1970s, were designed to enable investors to exchange fixed rates of borrowing for floating rates, or vice-versa - partly to offset the risk of wild interest rate swings in an inflationary world.
Commodity futures - which also allow investors to protect themselves from prices swings - have an even longer history.
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