Bloomberg News

U.K. Inflation-Protected Bonds Set for Worst Year in Decade

December 20, 2012

U.K. Inflation Debt Set for Worst Year in Decade on Index Review

An elderly man looks at the window display of a lighting store in Bury St. Edmunds, U.K. The country's inflation-protected securities are being undermined by a government plan to allow companies to reduce their pension deficit by changing valuation methods. Photographer: Chris Ratcliffe/Bloomberg

U.K. inflation-protected bonds are poised for their worst year in more than a decade as government proposals to change the way it calculates a gauge of retail prices threaten to lower payments on the debt.

Britain’s 290 billion-pound ($472 billion) market for securities linked to the retail-price index handed investors a loss of 1.2 percent as of yesterday, a reversal from its spot as the top performer in developed markets last year, when the bonds returned 21.4 percent. A recalculation of inflation indexes may save the government about 7 billion pounds a year by 2016-2017 at the expense of investors, according to an estimate by London- based research company Capital Economics Ltd.

Jil Matheson, the national statistician, will announce on Jan. 10 her recommendation for adjusting the retail-price index to address anomalies in clothing-price calculations. Baring Asset Management said it is holding back on purchasing index- linked gilts while Pacific Investment Management Co. said it is refraining from investing in so-called linkers with later maturities as the proposal risks undermining Britain’s credibility as a debt issuer.

Goalposts Moved

“I am unenthusiastic on long-dated U.K. index-linked bonds,” said Michael Amey, a London-based money manager at Pimco, which runs the world’s biggest bond fund. “They will continue to suffer due to uncertainty over the calculation. The debate over changes to the inflation measures gives a sense of original contracts being revised, and the investment goalposts being moved.”

The yield on index-linked securities maturing in November 2022 was at minus 0.78 percent as of 4 p.m. London time, compared with minus 0.91 percent on Dec. 7, the lowest level on a closing basis this year.

This year’s performance is the worst since 2001, when the bonds declined 1.56 percent, according to Bank of America Merrill Lynch’s U.K. Inflation-Linked Gilt Index.

Merrill’s Global Inflation-Linked Index gained 6.8 percent, while similar bonds from other developed markets returned from 0.67 percent in Sweden to 28 percent in Italy.

The review may add to concern the government is changing its calculations to help improve public finances, even though the independent Consumer Prices Advisory Committee is driving the investigation.

Interim Budget

Chancellor of the Exchequer George Osborne’s interim budget this month surprised lawmakers by including in economic projections income from a recent coupon transfer from the Bank of England and the planned sale of 4G mobile-phone spectrum licenses.

“There is a reputation issue that has to be considered if there were to be material change to the way the RPI is calculated,” said Paul Mueller, a money manager at Invesco Asset Management in London. “Investors want predictability. There is a view that if the government starts to tinker around with inflation calculations, they may do the same with other things. This doesn’t give the right signal to overseas investors about whether they invest in index-linked bonds or not.”

At issue is a widening difference between RPI and the consumer-price index, the basis for the Bank of England’s policy target, that’s due to differences in the mathematical formulae used to calculate price changes.

This disparity, known as the formula effect, was stable at about 0.5 percentage point until early 2010, CPAC said in its 2012 annual report. The gap widened to 1 percentage point after the ONS in February 2010 changed the way it calculates clothing prices in the RPI.

Four Approaches

Matheson has set out four approaches for addressing the issue, the first of which is to make no change. Of the other three options, the ONS estimates they would reduce RPI by between 0.4 percentage point and 0.7 percentage point, and shrink the formula effect by about 0.3 percentage point, narrow it to a minimal amount or eliminate it completely.

All of 10 economists surveyed on the matter by Bloomberg News said the ONS would avoid the first of Matheson’s options and make at least some alteration to the RPI.

The ONS will apply any change along with the annual update to the RPI in inflation data published on March 19. A change is inevitable, said Alan Clarke, an economist at Scotiabank Europe Plc in London.

‘Complete Farce’

Doing nothing “would be a complete farce,” Clarke said. “The feedback from the investor community will be so overwhelming they won’t be able to ignore that.”

Minutes of a meeting between the U.K.’s Debt Management Office and bondholders published Dec. 10 showed some potential buyers were shifting to short-dated securities pending the outcome of the review.

The losses suffered by U.K. index-linked bonds are unlikely to be repeated next year, said Mark Capleton, a fixed-income strategist at Bank of America Merrill Lynch in London. Clarity on the issue and a pause in the Bank of England’s bond purchases will help to restore demand for the securities, he said.

U.K. index-linked bonds recently recouped some lost ground, gaining 3.3 percent since the start of November.

The central bank bought no index-linked bonds under the 375 billion-pound quantitative-easing program it instigated to stimulate the economy. The purchases helped gilts outperform linkers for the first time since 2008, according to Bank of America Merrill Lynch indexes. Policy makers decided to pause the bond purchases in November.

‘I’m Bullish’

“Regardless of the CPAC outcome, I’m bullish about linkers on a break-even basis over the next 12 months,” Capleton said. “The conventional bond market will need to adjust to a world without quantitative easing. I think QE has masked a steady drift upward in inflation expectations.”

JPMorgan Chase & Co. estimated the market has already priced in 80 percent of the worst-case scenario for a change in the RPI.

The U.K. 20-year break-even rate, a market gauge of long- term inflation expectations derived from the yield gap between gilts and index-linked securities, fell to 2.46 percentage points in September, the lowest in more than three years. That compares with its five-year average of 3.25 percentage points. The rate was little changed today at 2.87 percentage points.

U.K. inflation-protected securities are also being undermined by a government plan to allow companies to reduce their pension deficit by changing valuation methods.

Because U.K. pension funds use a discount rate based primarily on long-maturity government bond yields to measure future obligations, a protracted period of low yields has increased their liabilities. Any change in this rule will potentially reduce demand for both long-dated gilts and inflation securities.

“There are a number of uncertainties ahead, but the inflation calculation review is the biggest factor that is holding us back from buying U.K. index-linked bonds,” said Dagmar Dvorak, a director of fixed-income and currencies in London at Baring Asset Management, which oversees $50 billion.

To contact the reporters on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net; Jennifer Ryan in London at jryan13@bloomberg.net

To contact the editors responsible for this story: Craig Stirling at cstirling1@bloomberg.net; Paul Dobson at pdobson2@bloomberg.net


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