This is for investment professionals only and should not be relied upon by private investors

FIXED INCOME

APRIL 2011

Global Inflation Linked Bonds An Introduction

With UK CPI remaining stubbornly well above 3%, the US Fed and other central banks providing unprecedented monetary stimulus, and the price of gold and other commodities having risen sharply, the threat of inflation has become an increasing concern for many investors. The outlook remains uncertain even the Bank of England is seemingly unclear, projecting a CPI range of 0.5% to slightly below 5% over the next two years. However, given the increased risks, it would be prudent for investors to consider an allocation to global inflation linked bonds in order to provide a degree of inflation protection, particularly to the fixed income element of client portfolios. Andy Weir is the portfolio manager of Fidelity Funds Global Inflation Linked Bond Fund. Andy joined Fidelity in 1997 as a Quantitative Fixed Income Analyst and was promoted to Director of Quantitative Research in 2002. He became a Portfolio Manager in December 2003 and has managed FF Global Inflation Linked Bond Fund since its launch in May 2008. Prior to joining Fidelity, Andy spent five years with JP Morgan Investment Management. He holds a BEng from Nottingham University. HOW IS AN INFLATION LINKED BOND DIFFERENT TO A CONVENTIONAL BOND? Like a conventional bond, an inflation linked bond (ILB) pays interest at fixed intervals and returns the principal at maturity. The main difference is that with an ILB, the interest rate and maturity value are adjusted by the rate of inflation over the life of the bond. As a result, conventional bonds, which have fixed coupons and therefore fixed nominal cash flows, are vulnerable to the threat of inflation, whereas ILBs offer protection against this inflationary threat. Very broadly, therefore, ILBs outperform in periods of low economic growth and high inflation, whereas conventional bonds tend to outperform in periods of low economic growth and low inflation. INFLATION LINKED BONDS BREAKEVEN RATES One way to compare ILBs and conventional bonds is to measure the breakeven rate, the rate at which inflation will need to increase to breakeven on returns from an ILB compared to a conventional bond. Take the following real-life example: UK Gilt 2027 currently yields 4.20% Inflation linked Gilt 2027 currently yields 0.75% Spread = 4.20% - 0.75% = 3.45% If inflation between now and 2027 averages 3.45% then you will breakeven on your returns. If inflation is above 3.45% then the return from the ILB will be better than the conventional Gilt.

Note that the coupon and the income yield on the ILB are considerably lower than the equivalent Gilt. This is because, in addition to fixed coupons, you receive the equivalent of realized inflation. HOW BIG IS THE GLOBAL INFLATION LINKED MARKET? The global inflation linked market is around US$1.8 trillion in size and has grown rapidly since 1997 when the US became the first non-UK issuer of inflation linked bonds (in their case called TIPS). As this chart shows, the US has now become the largest issuer, followed by the UK, then France, Italy, and more recently Germany. The market is dominated by government issuers which are predominantly AAA-rated, Italy and Japan being the main exceptions. By contrast, the corporate linker market is small, at around 11bn, illiquid, and concentrated primarily in the UK. There is also a US$412bn Emerging Market government inflation linked market which is relatively illiquid and highly concentrated in Latin American countries such as Brazil, Argentina and Chile.
2,000 1,800 UK 1,600 Market value USD billion 1,400 1,200 1,000 800 600 400 200 0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 New Zealand Poland Turkey South Africa Greece Sweden France Italy Germany Japan Canada Australia

Growth of Inflation-Linked Government Bond Market

US

CORRELATIONS OF RETURNS One of the key benefits of investing in inflation linked securities is the diversification benefit for client portfolios. As ILBs and conventional bonds typically perform differently in different parts of the economic cycle, so their correlation is also typically loose. There is just a 57% correlation between global inflation linked bonds and UK Gilts, for example. As the data shows, global inflation linked bonds have quite low correlations compared to a number of other fixed income and equity asset classes. In addition, the volatility of ILBs is also typically lower than conventional bonds. Correlations of returns Global ILB UK Index Linked UK Gilts UK Corporates High Yield UK Equities Global ILB 100% UK Index Linked 85% 100% UK Gilts 57% 59% 100% UK Corporate Bonds 54% 56% 61% 100% High Yield 23% 24% -18% 35% 100% UK Equities 6% 17% -14% 27% 56% 100%

Source: BofA Merrill Lynch, MSCI indices, based on monthly index total returns, hedged in GBP for UK, 31/07/1999 to 31/03/2011

WHY GLOBAL INSTEAD OF UK INFLATION LINKED BONDS? In our view, UK inflation linked bonds are structurally and consistently expensive due primarily to the fact that financial institutions such as insurance companies and pension funds are forced buyers. Since the US Treasury began issuing TIPS in 1997, a sterling-hedged portfolio of global inflation linked bonds has generated 131bps of extra return per annum over UK inflation linked Bonds. There is little reason to believe this consistent outperformance will change soon. In the UK, for example, the inflation linked market is currently pricing in a breakeven level of inflation of 3.2%, compared to 2.5% in the US and 2.3% in Germany. Our view is that on anything other than a short-term basis, global inflation linked bonds offer stronger performance potential. Global Inflation linked Bonds ( hedged) have consistently outperformed UK Inflation linked Bonds
Total Return Index

260 240 220 200 180 160 140 120 100 97

Global Inflation Linked Bonds ( hedged)

Extra return of 131 bps annualised

UK Index Linked Gilts

98

99

00

01

02

03

04

05

06

07

08

09

10

Source: Bloomberg, using BofA Merrill Lynch Global Governments, Inflation Linked ( hedged) and UK Index Linked Gilts 5-15 years indices (to 31/03/2011).

As well as the enhanced performance potential, global inflation linked bonds have historically had a strong correlation to the performance of domestic UK inflation linked bonds, thereby providing a hedge against local UK inflationary pressures. As long as inflation in developed markets continues to occur on a global basis, which is almost certainly going to be the case, then this correlation should also continue.

MARKET VALUATIONS INFLATION BREAKEVENS Despite growing concerns over the inflation outlook, the inflation linked bond market has yet to price in a noticeable increase in inflation expectations. As the chart below shows, historically the rate of inflation in the US, Europe and UK has been above current 10 year breakevens for 72%, 43% and 78% of the time respectively. This suggests the asset class offers good value relative to historic inflation experience. Current 10 year breakeven US Europe UK 2.52% 2.51% 3.27% Frequency of times regions inflation is higher than current breakeven level UK Index Linked 72% 43% 78% Inflation data over the last 30 years

25 20 % YoY change 15 10 5 0 -5 79 84

Europe

US

UK

89

94

99

04

09

Source: Bloomberg. Based on inflation data since 31/12/1979. *France CPI is used as a proxy for long history Europe inflation. Breakeven levels as of 04/04/2011.

WHY FIDELITY GLOBAL INFLATION LINKED BOND? Fidelity Global Inflation Linked Bond Fund has delivered consistently strong performance compared to its benchmark and competitor funds since launch in May 2008. The fund aims to provide broad exposure to global inflation linked markets and to be a vehicle through which investors can get a degree of inflation protection. For that reason it takes relatively small active positions vs its inflation benchmark. In order to implement a more flexible approach to the funds duration management, the benchmark of the fund was changed on 7 March 2011 and the benchmarks duration was reduced from 10 years to 5 years. The manager intends to keep the funds duration to +/-2.5 years relative to the index. This provides the fund with a definite edge against its competitors and aims to minimise risks if interest rates rise, while preserving a global inflation carry. The fund has achieved its strong performance through multiple sources of alpha. These include duration and yield curve positioning, relative value on bonds across markets and breakeven trades. A diverse set of uncorrelated positions ensures that no one strategy dominates risk or contribution to performance. Since launch the sterling-hedged Y share class of the Fidelitys Global Inflation Linked Bond Fund has generated an annualised return of 5.5% (net of fees) versus its sterling-hedged benchmark return of 5.0%. Fidelity Funds Global Inflation Linked Bond Performance (Y-GBP Hedged)
8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -0.1 -0.1 -1.0 YTD 1M 3M 6M 1Y Since Launch Ann. 0.8 0.7 0.6 1.1 1.1 1.1 0.7 0.6 0.8 0.2 % Fund (Gross) Fund (Net) Index 6.9 6.3 6.2 6.1 5.5 5.0

Source: FIL Ltd., 28/02/2011. FF Global Inflation linked Bond Fund's inception date is 29/05/2008. Performance shown is for the Y-GBP (hedged) share class and is in GBP. Benchmark: Barclays Capital World Government Inflation Linked Bond Index.

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