You can hedge inflation without giving up so much of the excess return available on riskier assets. David Hunter and Alistair Calvert report
Future inflation risk for many institutions, particularly pension funds, is significant. The largest fiscal and monetary stimulus in economic history, combined with demand for energy, commodities and raw materials from emerging economies, is generating both strong inflationary pressures and increased volatility. Each of these provides a major challenge for investors; combined, that challenge becomes a threat.
Unsurprisingly, institutions investing to meet inflation-linked liabilities are increasingly seeking to hedge inflation risks within their liability-driven investing (LDI) strategies. But this is not always easy, or cheap.
Different assets hedge inflation to varying degrees, in terms of average closeness and volatility of fit, and in terms of lag effects. Wise investment officers therefore seek first the ‘best' assets for hedging purposes. These are usually sovereign-issue index-linked bonds, preferably with inflation linkage defined as per the liabilities. Similar bonds issued by non-sovereigns, both companies and supranational institutions, are also usually considered.
As liquid, tradable assets these bonds are certainly attractive, and carrying lowest credit risk, one would expect the real yield to be relatively small. Unfortunately the limited supply of such assets relative to the demand has pushed real yields on inflation-linked bonds beyond ‘normality' to all-time lows.
Investors concerned about inflation are therefore looking elsewhere to meet their hedging needs. Bespoke swaps with investment banks have some advantages and volumes for pension schemes seeking to hedge their inflation liabilities through swaps are rising steadily. They can be tailored to the specific inflation profile of an institution but are usually less reversible or liquid than tradable sovereigns. In theory a premium for the credit risk of the bank versus a sovereign issuer should be on offer, although in practice this has at times been negative. Some investors also feel less comfortable when trying to understand the fees being made from the trade.
Demand for hedging inflation within LDI approaches therefore continues apace. While bespoke solutions at small or zero yield enhancement to index-linked sovereign bonds can help reduce risk, many institutions want to have their cake and to be able to eat it too. They would like to hedge inflation of course, but not give up so much on the excess return potential available from ‘riskier' assets such as equities.
Against this background, many institutions are considering other credit-related assets offering fundamental inflation-hedging characteristics. Property-based assets such as ground rent securitisation and sale/leaseback can provide the inflation protection benefits required and are being met with some interest. The former can be difficult to obtain in small quantities and deliver at best a moderate yield enhancement alongside inflation-hedging qualities. However, niche sale/leaseback strategies offer investible opportunities for even small to medium-sized pension schemes seeking inflation protection, and with significant potential upside.
As with the ground-rent securitisation approach, the inflation protection in a sale/leaseback portfolio comes from the inflation-linked rent increases during the term of a property lease. In a sale/leaseback transaction an owner-occupier divests property assets and simultaneously commits itself to lease those assets back under a long-term lease agreement. The seller realises cash proceeds from the transaction while the purchaser takes title to leased property assets, which it may hold or sell into the market. The sale/leaseback structure has been widely adopted by North American companies, while Europe in general, but particularly continental Europe, has been slower to understand the potential benefits of sale/leaseback transactions.
The motivation for a company to enter into a sale/leaseback varies. Often deals are corporate-finance motivated, for example, companies seeking to pay down debt or requiring capital to fund growth. Pressure from investors for companies to invest their capital in core activities (rather than real estate) is also likely to be a driver in the current market. The sale/leaseback may often provide a long-term financing solution appropriately matched to the long-term view that a company has for core operating assets. This is sometimes appropriate as it eliminates refinancing risk, since there is no obligation to repurchase the properties at the end of the lease term. Companies may also enter into sale/leaseback transactions as a result of a corporate policy to lease rather than own the real estate that they need.
The key to creating higher-return sale/leasebacks is to identify investments where an information asymmetry exists between the seller and buyer.
On the business side the buyer must understand the seller's business as deeply as would a private equity investor of the business to ensure that although the seller wishes to take the asset off balance sheet it remains mission critical to the business and will be the last asset to be disposed of in the event of credit difficulties.
On the leasing side the buyer then adds further value due to its in-depth real estate and leasing expertise, by structuring "out of the market" lease contracts through negotiation of lease term, repairing obligations, high initial yields and additional security such as guarantees and collateral.
In a sale/leaseback transaction the two parties prescribe all of the terms of the lease contract. Certainty of the minimum net income from a sale/leaseback can be obtained where a triple net lease is concluded. Under such a contract the tenant pays for all real estate costs, including insurance, taxes and maintenance. When it comes to rent indexation, it is generally permissible to structure upwards-only inflation-indexed rent reviews. The frequency with which rent is increased may vary from lease to lease, but forms part of the lease negotiation process. When structured correctly, a sale/leaseback investment should provide its investors with an efficient inflation hedge as rental income will increase in line with inflation.
Where sale/leasebacks are leveraged with fixed-rate debt, investors may realise a multiple increase of inflation. That is to say that if rents increase by 2% while interest expenses remain constant, then the leveraged cash flows from the sale/leaseback will increase by a multiple of 2%. The multiple will depend on the respective rental yield, interest rate and amount of leverage used.
A diversified portfolio of sale/leaseback investments, financed with fixed-rate debt, should offer returns that are closely linked to the benchmark inflation indices used in pension liability definitions. Added risk and yield premia arise from the credit exposure/rating of the tenants within a portfolio and from active property management. The sale/leaseback differs from other forms of real estate investing where there is less emphasis on the credit quality of the tenant, since the long-term inflation-linked cash flows from a sale/leaseback are predicated on there not being a tenant default during the lease term. It also differs as investors in sale/leasebacks generally do not take development, letting or property operating risks. Under a triple net (ie, fully repairing and insuring (FRI)) lease these risks are externalised to the tenant.
Few specialist sale/leaseback investors exist. General real estate investors often lack sufficient experience in lease structuring to extract the maximum value from a sale/leaseback. They may also place too little importance on the ability of a tenant to meet its long-term lease obligations, or lack the credit underwriting skills to appropriately assess this. Funds operated by experienced managers using deep credit analysis should therefore be sought to minimise risk.
Particularly attractive are those producing high cash distributions from running yields. Such distributions can help a pension scheme's shorter-term cash flows meet its more immediate liabilities, whilst the overall allocation to such assets can limit any reduction in excess returns that an LDI approach to strategy often delivers alongside reduced risk.
Alistair Calvert is managing partner at ThreadGreen David Hunter is chief executive at Valiance