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Analysis: Index-linked gilts face RPI uncertainty

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The index-linked gilt market faces months of uncertainty and the likelihood of lower returns as plans to change how inflation is measured progress.

Proposals to improve the retail prices index could also leave the Government open to accusations of default and may “ruin” the market for index-linked gilts, commentators have argued.

prices advisory committee and could then be put forward for implementation.

The move is intended to improve RPI by reducing the so-called formula effect, which tends to overstate the pace at which the cost of living is rising and is caused by RPI using different formulae to the consumer prices index when aggregating price changes.

The CPAC appears to favour completely aligning the formulae used to work out RPI with those used for CPI. This would eliminate the formula effect and would bring RPI down by about 0.9 per cent.

There are clear winners to this move. Capital Economics estimates that the Government would save about £7bn a year by 2016/17 as it would have to pay less interest on index-linked gilts, where the coupons change in line with moves in RPI.

However, this would be to the detriment of index-linked gilt holders. Capital Economics singles out these investors as the “biggest losers” of the successful implementation of the proposed changes.

The macroeconomic consultancy says: “Both coupon payments and the redemption value of index-linked gilts depend on RPI inflation. So a lower rate for RPI inflation would cause index-linked gilts to be worth less (in nominal terms) than they otherwise would have been.”

Bestinvest analyst Robert Harley says the proposed move has already had an effect on index-linked gilts, especially at the shorter-dated end of the market. These bonds are more sensitive to changes in inflation expectations and have seen their value fall as the risk grows that RPI will be amended to a lower level.

M&G UK Inflation Linked Corporate Bond fund co-manager Ben Lord is a critic of changing how RPI is worked and argues that it could be viewed as an event of default.

“We bought these securities on the basis that we would be paid RPI, which we know changes in terms of items and weightings on an annual basis but according to changes in spending habits rather than Government policy,” he says.

Lord notes index-linked gilts could become less attractive to investors as their returns will lower than they would have been otherwise.

Axa Index Linked Bond fund manager David Dyer expects to see increased uncertainty in the index-linked gilt market until it is decided whether or not the changes will be carried out.

“This may cause some problems but it does not diminish the overall argument for the asset class,” he adds. “As an asset class, we have seen increased interest because investors are concerned about possible future inflation.”

Furthermore, the manager points out that issues such as the inflationary side effect of quantitative easing and persistent increases in food prices will continue to make inflation a leading concern among investors.

Rathbone Unit Trust Management chief investment officer Julian Chillingworth agrees the investment case for index-linked gilts will not be significantly diminished by the move.

But he notes that existing holders of the securities look certain to lose out under the proposals and warns against complacency among investors.

“We are slightly surprised that there has not been more discussion around this,” Chillingworth says. “For a lot of investors, it’s not hit their radar screen yet. We as an industry have to get our act together and if we are unhappy we ought to voice our opinions.”

He still expects the securities to remain popular: “At the end of the day, they are one of the few ways to protect your clients from a rise in inflation. We can argue about how to calculate inflation but it still holds that they will still do that.”

Standard Life Global Inflation Linked Bond fund lead manager Jonathan Gibbs adds the change has wide-reaching consequences that go beyond the index-linked gilt market.

“Any attempt to introduce ‘improvements’ to the RPI index methodology is complicated by its considerable importance to financial markets,” Gibbs notes.

“The most obvious dependent would be the sizeable RPI-linked gilt market, worth £347bn. However, many commercial property assets, PFI-related structures and infrastructure vehicles have liabilities or cashflows explicitly linked to the RPI.

“In addition, utility companies’ pricing structures are statutorily linked to RPI and, of course, many pension schemes are still linked in some way to the index.”


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