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Categorized | Capital Markets

‘Linker’ gilts rebound after shake-up wobble

Posted on October 3, 2016


Britain’s financial markets are locked in a tug of war over radical proposals to shake up the UK’s pension industry that could trigger large-scale losses for investors in index-linked government bonds.

The Financial Times reported last week that MPs were considering a plan to permit private sector pension schemes to break promises that link payouts to increases in consumer prices in a bid to ease the effect of growing pension fund deficits.

    The news led to a sharp drop in prices for index-linked gilts used by pension funds to match inflation promises with prices for a 2068 inflation-linked bond down 10 basis points on the day.

    However, British government bond fund managers say demand for so-called “linkers” has quickly rebounded, outstripping appetite for conventional government bonds in spite of the potential policy change.

    Year to date, the difference in performance between the two is stark, with prices for the inflation-linked 2068 gilt up 65 per cent, against a 39 per cent price increase in conventional gilts.

    A work and pensions select committee will examine ideas to increase pension scheme flexibility this month as actuarial consultant Mercer warns that UK corporate profits are coming under pressure from rising pension costs triggered by the fall in bond yields used to calculate liabilities.

    Investors point out that the need for insurance companies and pension funds to match liabilities has not yet been eliminated, with some sceptical that any change will take place.

    Mike Riddell, gilt fund manager at Allianz Global Investors, added that, with only two sales of index-linked gilts planned for the rest of the year, demand for existing bonds should stay healthy.

    “The short- to medium-term technicals for linkers are trumping anything else,” said Mr Riddell.

    “There has been very little supply and there’s a constant drip of demand from pension funds and liability-driven investors [that is, insurance companies].”

    Following the UK’s vote at the end of June to leave the EU, demand for index-linked bonds has exceeded the rally in vanilla government bonds as investors bet on a pick-up in inflation from current ultra-low levels.

    The UK’s five-year ‘break-even inflation rate’ — the difference between the yield on conventional gilts and index-linked gilts — is currently 2.7 per cent, up from 2.2 per cent before the EU referendum, as markets factor in the long-term effect of sterling’s fall on the price of imported goods.

    But regardless of the increase in inflation and the pressure on pension funds struggling with growing deficits, Luke Hickmore at Aberdeen Asset Management is doubtful that any significant change to pension fund inflation matching will occur.

    “If the rules actually change then I think you could expect to see a serious move in the prices for index-linked gilts,” said Luke Hickmore, senior investment manager at Aberdeen Asset Management.

    “But so far this is speculation and I’m not sure there is the political will to make the change — in spite of the pressure from certain politicians. People expect their pensions to increase over time — the method of calculation is not perfect but changing it would create a huge market shift that I’m not sure politicians will want.”