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The Actuary The magazine of the Institute & Faculty of Actuaries

Inflation markets come of age

W hat do you know about UK index-linked gilts? I am willing to bet that
for a large number of readers, one of your first thoughts was that they
protect against inflation with an eight-month time lag. Being an index-linked fund manager rather than a mind-reader, how do I know that? Many years as an examiner and marker of actuarial investment papers has taught me that if an actuarial exam asks for the features of index-linked gilts, then the eight-month time lag is the one fact that everyone seems to know. Given that, I am sorry to have to break the news that you will have to re-learn that fact, because the length of the time lag is being shortened. This is just one of the ways in which the index-linked bond market has been developing over recent years.

Shortening the time lag
It is now a quarter of a century since Sir Harold Wilson published a report that reviewed the function of UK financial institutions and recommended that gilts were issued with coupons indexed to average earnings for purchase by pension funds. The first index-linked gilts were issued in the following year, but they were indexed to the more widely known Retail Price Index. Initially, only pension funds were allowed to purchase them, but this restriction was removed a year later. With interest payments made every six months, it was decided that an eight-month inflation time lag had to be made in order that an interest payment was always known before the date of payment of the previous one. This was necessary for the calculation of accrued interest (the amount of interest accumulated since the previous payment).
However, when the Canadian authorities decided to issue inflation-linked bonds in 1991, they used a different method. Instead of requiring accrued interest to accumulate at a constant rate over the six-month period, an index ratio was calculated each day based on more recent inflation and this was applied to the quoted price and accrued interest. Consequently, prices were quoted in real and not nominal terms and it was possible to shorten the time lag to just three months. This ‘Canadian model’ has become the standard for most international inflation-linked markets and it is no surprise that the UK authorities have decided to apply it for all new index-linked gilts. Note, however, that it only applies to issues of new bonds and not further issuance of existing bonds for which the eight month time lag still applies. To aid in distinguishing between the two types of issue, new bonds are to be given the title Treasury Gilt, whereas old issues were designated Treasury Stock. For the full technical details, see the website of the UK Debt Management Office (www.dmo.gov.uk).

Redemption value
There is still, however, one difference between the way that inflation is allowed for on UK index-linked gilts compared with overseas inflation-linked markets. In most (but not all) non-UK markets, the final redemption value is guaranteed to be no lower than the nominal value of the bond if the price index level is lower at redemption than when the bond was first issued. Note that this only protects against deflation over the whole life of the bond, not in each individual year. The UK authorities have always refused to issue bonds with this protection arguing that it would reduce the debt smoothing advantages to the Treasury as issuer of index-linked gilts. Although most investors may feel that the probability of prices having fallen over the entire life of an index-linked bond is small, the absence of this protection is said to have reduced the demand for UK index-linked gilts from some European investors because of the accounting implications.

Other varieties
Earlier this year, the UK authorities consulted on the possibility of issuing annuity based index-linked (and fixed-income) gilts. However, it was thought that the demand for these types of issue would not justify the reduced overall liquidity that may result from fragmenting the current market. Similar arguments have applied when discussing the issuance of bonds linked to other inflation measures such as Limited Price Indexation (RPI with a floor of 0% and a cap at 3% or 5%) or the Harmonised CPI (the measure targeted by the Bank of England’s Monetary Policy Committee).

Demand for inflation
When index-linked gilts were first issued, some commentators were prepared to argue that there would be value in these new investments, even if they were priced with a 0% real yield in fact the first issue came with a real yield of 2%. Twenty-five years later, the yield on the current ten-year UK index-linked stock has spent the majority of the past 12 months trading between 1.7% and 2.1%, so it might be thought that little had changed. However, it should not be forgotten that in the first few years after their issue they struggled to find natural demand and real yields rose as high as 4%.
Yields have been driven lower as changing legislation has seen a greater proportion of pension scheme benefits linked explicitly to inflation. With risk appetite low, following the gyrations in the equity markets, trustees are choosing to invest in index-linked bonds, which they believe will match their liabilities more closely. In many cases, these liabilities are longer than the assets available in the bond market. The effect of this can be seen by looking at the chart of the breakeven inflation curve (showing the difference between nominal and real yields of the same maturity), which has become significantly upward sloping as a result of demand for inflation protection. In response, the UK government is set to issue a 50-year bond (another first for the UK) in September and this will become the first UK issue with a three-month time lag.
Indeed, figure 1 shows that the effects of the demand for long-dated inflation protection have had an even more extreme effect on the sterling inflation swap curve. The inflation swap market has seen dramatic growth in turnover in the past year, but most demand for protection against inflation has been at longer maturities, whereas sellers of inflation have been greater at shorter terms. The inflation swap market offers a more bespoke matching possibility for pension schemes. Investors can now match their liabilities more closely both by maturity and their nature (eg Limited Price Inflation liabilities).

Corporate and international issuance
Governments are still by far the major issuers of inflation-linked debt and the equivalent corporate sector has taken a longer period to develop. The number of non-government issuers willing to take on an open-ended commitment in nominal terms has been limited. In addition, they have come from a limited number of sectors (notably utilities) making portfolio diversification difficult. However, there have been opportunities in the inflation-linked credit market, notably in the UK and France. Indeed, the additional yield available on index-linked credit compared to government issues has frequently been higher than that on equivalent fixed-rate issues. In addition, with different maturity dates to government issues, investors are able to match liabilities more precisely.
The international inflation-linked market took some time to develop and some ten years later the outward looking UK investor could then only diversify into Canada and Australia. It was not until the mid-1990s that a global market really started to develop with the entrance of France and the United States, while during the current year international investors can add Japan and Germany to the list of available markets. Interestingly, many of these other international markets also took time to develop a natural investor base and the initial performance was poor. This created great opportunities for internationally minded investors from the UK to invest at higher real yields than those available in the domestic market.
The index-linked market has come a long way since the bonds were first proposed 25 years ago. This year they will finally become available in all of the G7 markets. There is now a standard international convention for the inflation time lag and bonds will now be available with maturities up to 50 years. A liquid derivative market has been established. Truly it can be said that the index-linked market, the one true low-risk investment class that offers guaranteed real returns, has come of age.