UK - Government plans to switch inflation-linked uplifts for final salary pension schemes from the retail price index (RPI) to the consumer price index (CPI) have had an instant and negative effect on the UK index-linked gilt market, Aegon Asset Management has said.
European head of rates Stephen Jones said real yields are seven to nine basis points higher at the long end of the real yield curve, with a similar move in breakevens (i.e. the difference between long-dated conventional gilt yields and index-linked yields) following the announcement by pensions minister Steve Webb (pictured) earlier this week (GP Online July 9)
This has all happened against a background of an overall flat to only slightly weaker conventional gilt market, said Jones.
"Uncertainty is probably the main influence and driver here," he added. "What role will an RPI-based inflation market have if asset liability managers now focus on CPI? Will the UK Debt Management Office (DMO) move to issuing a CPI-based index-linked inflation product? Will the existing RPI-based stock become illiquid and, in effect, in terminal decline? Will some sort of exchange/alteration of terms be offered for existing bonds into a CPI-basis if the DMO wants to create an instantly liquid CPI market?"
Near-term supply is also weighing on the market with a syndication of 2040 index-linked gilts coming up over the next couple of weeks, Jones said. This could lead to further uncertainty over whether there is sufficient demand to get the stock away in the size the market has got used to for index-linked syndications, and if so, what yield would be required to clear the stock.
"Having created a potentially large amount of CPI liability, and with no CPI asset available to hedge it, the likelihood is that all liability-driven investment (LDI) hedging - and hence assumed demand for index-linked gilts - will probably be put on hold until the situation becomes clearer," said Jones.
"With liabilities lower on the back of using a CPI assumption, demand from hedging activity will inevitably be lower. This argument is, however, offset to some extent by the fact that the overall pension fund position is significantly under-hedged anyway - what difference does it really make if the overall need for protection is now say £350bn rather than £500bn?
"Going forward, there is a chance that more hedging will be done in the conventional coupon markets rather than in inflation markets. The relationship between CPI and conventional bonds looks less volatile than the relationship with RPI. Some may take the view that with inflation liabilities permanently reduced it is not worth hedging at all.
"In short, uncertainty and near-term supply have created pressures for index-linked gilts. I believe they could sell off another five to 10 basis points relative to conventional gilts. Not a disaster, to my mind, and with it comes the potential to pick up some cheap bonds around the 2040 syndication if things overshoot over the next couple of weeks."
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