Gilty conscience

The main investors in the gilts market are pension funds, but why?

This year, index-linked gilts have returned 27% (to the end of September), outperforming conventional gilts (+14%) and even global equities (+21%) over the same period. In both June and August, index-linked gilts gained 10%, the two largest monthly returns in the 24 years of the FTSE Actuaries UK Index-Linked All Stocks index.

Collapsing real yields have powered this meteoric rise. They have not been driven by inflation – although expectations have picked up since the UK referendum – but mainly by collapsing nominal yields, and the longer duration of the index-linked gilt index.

Since the beginning of the year nominal 20-year yields have fallen by 1.16%, while real yields (the sum of nominal yields less inflation) have only fallen slightly further (-1.23%). More importantly, what has driven outperformance of the index-linked gilts is their real duration of around 23.5 years (i.e. for a 1% fall in real yields, index-linked gilts will gain 23.5% in aggregate). Conventional gilts’ more modest performance can be explained by the lower duration of their index (11.4 years).

This rally has left index-linked gilts expensive. On 12 October the UK’s Debt Management Office issued a tranche of an index-linked gilt which will mature in 2036 for a record low real yield of -1.847%. Index-linked gilts protect investors from the uncertainties of inflation, but at a steep price: an investor holding this gilt to maturity in 20 years will experience a loss of spending power (in Retail Price Index terms) of 31%. This does not seem to present an enticing investment opportunity, so what has driven the market to these levels?

Mismatch between the size of the index-linked market and its investors

The main investors in the gilts market are pension funds, which seek to match assets against their future liabilities and dominate the index-linked market. Looking at the pension regulator’s ‘Purple Book’, along with data from the Debt Management Office, pensions owned around 72% of the entire index-linked gilt market as of March 2015. It is likely that this is concentrated in the longer-dated issues because of the long-dated nature of pension liabilities.

As pension funds mature, they allocate more to bonds (at the expense of equities) in order to reduce risk, and given most UK pensions have inflation-linked liabilities, the demand for index-linked gilts is likely to remain high. Pension funds are motivated by risk mitigation, rather than price. They generally buy bonds to hold to maturity so are not a source of liquidity for the broader market. Their market domination, and infrequent trading, makes a perfect environment for prices to become divorced from economic fundamentals.

Where next for the market?

Expectations of increasing inflation do, of course, have a positive effect on the price of index-linked gilts. Breakeven inflation rates (the bond market’s best guess at future inflation) have stepped up since the UK’s referendum in June on expectations of increasing inflation due to weaker sterling. Ten-year breakeven rates have risen from 2.3% at the end of May to 2.9% as of the middle of October.

In May, markets were sanguine about the UK’s prospects of remaining in the European Union and there seemed little catalyst for a pickup in inflation. Since then there has been a 15% devaluation in trade-weighted sterling. The Bank of England has suggested it would expect a move of this size to increase the Consumer Price Index by 3-5%. That rise may be distributed over the course of a few years, but it could be faster given the speed of the devaluation. Current breakeven rates, though higher, might look better value than they did previously. If realised inflation is higher than the breakeven rate, investors are better off in index-linked gilts rather than conventional.

Nonetheless, inflated asset prices are always at risk of corrections: the price of index-linked gilts has fallen 4% since 6 October, illustrating some of the risk inherent to that asset class. While it seems unlikely that we will experience a prolonged environment of rising nominal yields not matched by inflation (rising real yields), thin trading volume leaves index-linked gilts vulnerable to price shocks.



*All figures taken from the Debt Management Office, the pensions regulator and Bloomberg


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