UK linkers becoming stinkers

In the recent emergency UK budget it was announced that public sector indexation would change from RPI to CPI from April 2011.  Now, the government is proposing moving private sector schemes and the Pension Protection Fund (PPF) indexation to CPI too.  As Pensions Minister Steve Webb argued, it makes sense switching to CPI as it’s the measure that the BoE targets and (slightly more dubiously) CPI is a more appropriate measure of pension recipients’ inflation experiences.

RPI has historically been higher than CPI, exceeding CPI by 0.55% on average over the last twenty years, so if the differential between the measures continues in future then this proposed change would reduce pension fund deficits but would penalise scheme members if (and presumably when) it is implemented.

The problem with this proposal is that you can’t buy CPI linked assets in the UK – they don’t exist.  While the correlation between RPI and CPI is reasonably close as you’d expect, the difference was as high as 3.1% in 1989 and is currently a relatively large 1.7%.  RPI linked assets are still a better hedge against inflation than any other asset class, but there will definitely need to be CPI linked assets at some stage.

It may be possible to restructure the existing RPI linked index-linked gilts, but the easiest thing would be to issue new CPI linked index-linked gilts.  This would make the RPI linked assets currently in existence pretty redundant.  The good news is that this change, assuming it happens, will likely take years rather than months to implement and even then could well be gradual.  Furthermore, in the meantime investors have no choice other than to continue buying RPI linked assets to hedge against inflation.

But it’s clearly a negative for inflation linked gilts overall, and we’re seeing that in terms of price action today.   Longer dated index-linked gilts are getting hit hardest, partly because they’re longer duration so are more sensitive to changes in yields, and partly because the biggest buyers of long linkers are the pension funds.  At the time of writing, UKTI 1.125% 2037s are down over 2% so far today, while the UKTI 0.5% 2050s are down 3.5%.

Linkers maturing in 20 years or longer have now been in a bear market year to date, which is quite incredible given that long dated conventional gilts (ie those maturing in 15 years or longer) have returned over 13% over the period.   The significant underperformance of linkers has come about despite the UK inflation rate rising significantly this year, with the year on year rate of CPI climbing from 2.9% in December to 3.4% in May – as mentioned in October here, changes in the real yield is a much more important driver of returns for longer dated index-linked gilts than changes in short term inflation.