Inflation – Feature
for institutional investors in order to tackle changes in price levels. But with only a quarter of gilts issued offering inflation hedges, 80% of whom are already owned by pension schemes, the mar- ket is heavily oversubscribed. And as defined benefit (DB) schemes are maturing and in turn increasing their fixed income exposure, demand for index-linked gilts is likely to increase. Indeed, the Pension Insurance Corporation estimated in 2014 that it could lead to a cumulative net shortage of index- linked gilts amounting to more than £500bn. Enter the retail price inflation (RPI) reform, which is likely to complicate things further. By the end of last year, the then chancellor, Sajid Javid, announced plans to align the way RPI is measured with the more commonly used consumer price inflation plus housing (CPIH). This could have significant effects for returns on index-linked gilts, which are so far linked to RPI. Because the current RPI formula slightly overstates inflation by about 1% compared to CPIH, the revised RPI for- mula would lead to lower investment returns from index linked gilts. By changing the inflation measure, the government could save a tidy sum of money. The questions to be confirmed now is how it could affect outstanding government commitments and whether the reform should enter effect in five or 10 years’ time. If the reform is established in 2030, the value of outstanding linkers could drop by £90bn, introducing the reform in 2025, it could drop by up to £120bn, Insight Investment predicts. While the initial announcement has led to a slowdown of demand for linkers, the delay of the consultation due to Covid and falling prices for index-linked gilts at the beginning of the year meant that demand increased, Evan Guppy explains. “Over the past six months, quite a few investors have given up on waiting for the outcome of the consultation and quite a lot of pent up demand has been released into the market,” he says. But Kevin Wesbroom, a professional trustee at Capital Cran- field, argues that the outcome of the consultation is too uncer- tain to drive demand. “Whether it makes sense to buy linkers now is slightly subtle. It depends on if the price you are paying today fully allows for the fact that the RPI will change. “So the interesting question is how the market is coming up with a view on what the government will get away with,” he adds. “My understanding from speaking to investment advis- ers is that about half of the change has been reflected.”
Opportunity costs With the outlook on inflation remaining as uncertain as ever, Trow argues that opportunity costs of index linkers are a key factor to consider. His scheme pursues a barbell strategy, where a relatively higher equity exposure is offset with index- linked gilts to match liabilities. But he is also acutely aware that
Issue 96 | September 2020 | portfolio institutional | 31
an over-exposure to linkers could come at a price. “If nothing happens the returns are extraordinarily low and the opportunity costs are worth considering,” he adds. “Lots of people tried to fight the equity market rebound after 2009 and it got to the point where the market recovered by so much that people who had been in cash or safe assets like linkers felt that it was too late in the game to chase the market. Yet the market did keep going on for another decade.” Guppy highlights that while alternative inflation hedges, com- modities in particular, might offer higher returns, make it much harder to tie them to the movement of inflation risks and liabilities. “If commodity prices fell sharply as a result of struc- tural changes in demand but prices of other parts of the infla- tion basked might rise so a commodity strategy might not be perfectly matched to liabilities,” he says. Wesbroom also cautions that the lack of supply in linkers means that it would be impossible to fully hedge inflation risks through linkers alone. “If every scheme decided to go for index-linked bonds, there would simply not be enough out there to satisfy demand. There are a few overseas funds that you might be able to use but the inflation rate would obviously not be as closely tied to UK levels.”
While a precise match of liabilities through inflation-linked products was always a purely theoretical promise, the uncer- tainty of the inflation outlook and the returns on index-linked gilts are likely to make it a lot harder to achieve.
If every scheme decided to go for index-linked bonds, there would simply not be enough out there to satisfy
demand. Kevin Wesbroom, Capital Cranfield
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