Axa IM’s Lucy Barron and David Dyer explain calls for UK to issue CPI linkers
UK government bonds with returns linked to rates of inflation should be issued against the Consumer Price Index (CPI) in addition to the Retail Price Index (RPI) argue Lucy Barron, LDI solutions strategist and David Dyer, senior fixed income portfolio manager at Axa Investment Managers.
In the aftermath of the recent decision by the UK Office For National Statistics (ONS) not to make material changes to the RPI-based measure of inflation, the uncertainty has been reduced regarding the extent to which the RPI would be altered and the degree to which such changes would cause the RPI measure to converge towards the CPI measure of inflation.
Instead of convergence, we now know that ‘for the foreseeable future’ the methodological differences between RPI and CPI will continue and the wedge between respective inflation measures will remain wide. The Office for Budget Responsibility in 2011 estimated the plausible range for the long-run difference between the two measures to be 1.3%-1.5% pa.
Moreover, one of the main reasons stated at the previous CPI consultation for not issuing CPI-linked gilts was uncertainty around the inclusion of owner occupiers’ housing in the CPI. With this now resolved, such uncertainties are no longer a reason for the issuing authorities to keep CPI-linked bonds off the agenda. Thus, with the dust settling on the ONS decision, the door should now be open to recommence discussions on the case for issuing CPI linkers.
Potential demand for CPI Inflation-linked bonds is persuasive and growing:
– Increased pensions demand driven by statutory changes. By far the greatest case for issuance of CPI linkers comes from changes made by the government itself following, the announcement at the June 2010 Budget and subsequent statements that, in future, pension fund liabilities should be linked to the CPI, rather than RPI. Although the subsequent act (Pensions Act 2011) did not force all private sector pension schemes to shift to the CPI, those funds which did not explicitly state RPI as the basis for revaluing deferred pensions and/or
determining pension increases in the scheme rules were permitted to move to CPI. Public sector pension schemes were automatically moved to CPI revaluation and pension increases from 2011 onwards.
– This decision to move to using the CPI as the measure of price inflation for determining the statutory minimum percentage increase for revaluation and pension increases has markedly increased the need for CPI-linked investments. ‘The largest potential investor group for CPI-linked gilts is likely to come from the LDI activity of DB pension schemes, where schemes seek to match the characteristics of their liabilities with specific investments’ – DMO November 2011.
– De-risking likely to highlight need for CPI-linked gilts even further, relative to RPI-linked. The focus on CPI Index-linked bonds comes at a time when defined benefit pension funds are focussing more and more on reducing risks between their assets and liabilities. As the overall funding risk for these schemes is reduced and inflation-linked investments
as an asset class take on a larger proportion of portfolios, the risk which arises from hedging
CPI-linked liabilities with RPI-linked instruments becomes increasingly important. Therefore, given that the RPI-linked bonds are the only inflation-linked gilts that are available presently, we believe that there would be significant demand for CPI linkers
outright for additional hedging and through switching from existing RPI linkers.
– Demand from insurance companies as a result of pension buy-in/buy-out. Following the changes in 2011, an increasing proportion of pension liabilities being transferred to insurance companies are linked to CPI. Given the additional reserves required when insurers hold non-matching assets against the liabilities, there would be strong demand for CPI-linkers provided that they were reasonably priced versus RPI-linkers.
– Downgrading of RPI favours CPI for overseas investors and 60-year linkers. Although the RPI methodology was left unchanged, it is going to be re-assessed to determine whether it will still be designated a National Statistic (as defined by the ONS). This forewarns of a likely downgrading and deemphasising in the importance of the RPI.
– The CPI, however, is a National Statistic and is not only well defined but is also recognisable for international investors and comparable with other international CPI measures. In the longer term, there should be wider market demand for CPI-linked instruments from overseas.
-Furthermore, with talk of investor demand for ultralong inflation-linked (60-years) there would clearly be a need to issue against a credible inflation measure – with the RPI likely to be de-emphasised, there is a clear case for issuing against the more credible alternative of the CPI.