UK INFLATION-LINKED GILTS - Engaged Investor · CONCLUSION Inflation-linked bonds have a...
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Trustee MasterClass Trustee MasterClass A NEW TYPE OF BOND The first index-linked UK government bond (or gilt) was issued in 1981 and was the first bond to protect the value of the original investment (or principal) against inflation. Other issuers have followed, so providing inflation-linked bonds across several countries globally. Many investors have traditionally increased allocations to commodities or equities as an indirect means of protecting their portfolios against inflation. However, inflation-linked bonds are the only asset class that explicitly protects against inflation by directly compensating the holder for movements in an inflation index. Inflation-linked bonds are an attractive asset class for pension schemes, offering trustees an effective long-term tool for hedging their inflation-linked liabilities. The index-linked gilt market has tripled in size since 2003 and represents around a fifth of outstanding UK government debt 1 . Moreover, issuance is increasingly weighted towards bonds with longer maturities, some out to 2055, to meet pension fund demand for assets matching longer-dated liabilities. MINIMISING RISK The two major risks in investing in traditional gilts are usually changes in inflation and changes in real interest rates (ie interest rates excluding the inflation rate). Upward moves in either inflation or rates are usually negative for bondholders. For investors looking to invest in fixed income assets, the prospect of higher inflation has always tended to be a concern. However, inflation-linked bonds counter this concern by allowing investors to hedge against that inflation risk. Inflation-linked gilts provide inflation protection through a change to the value of the bond based on changes in the inflation rate as measured by the Retail Prices Index (RPI) (See Economic Concept Masterclass – Jan/Feb 2010). There are two different types of index- linked gilts – ‘8 month-lag linkers’and ‘3 month-lag linkers’. ■ 8 month-lag linkers: The original type of index-linked gilt launched in 1981. The inflation rate used for each coupon, or interest, payment on these bonds is based on the inflation data from eight months previously. The inflation uplift to the principal is included in the price of the bond. ■ 3 month-lag linkers: Introduced in 2005 to provide investors with inflation-linked UK government bonds broadly in line with the methodology used for other inflation-linked government bonds issued by governments globally. The rate on the bond is based on the inflation data available three months previously, and the indexation of both coupon and principal is calculated separately from the price of the bond THE REAL YIELD The yield of an inflation-linked gilt is often described as the real yield, or the yield to maturity in excess of the presumed inflation rate. For instance, a bond with a real yield of 0.33% is expected to return 0.33% above inflation if held to maturity. Interestingly, with the current low yield levels for shorter maturity conventional gilts, some shorter maturity inflation-linked gilts have a negative real yield. This edition of Trustee Masterclass explains the role of inflation-linked government bonds in pension investment UK INFLATION-LINKED GILTS 1 ENGAGED T H E T R U S T E E M A G A Z I N E in association with
Transcript of UK INFLATION-LINKED GILTS - Engaged Investor · CONCLUSION Inflation-linked bonds have a...
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A NEW TYPE OF BONDThe first index-linked UK government bond (orgilt) was issued in 1981 and was the first bondto protect the value of the original investment(or principal) against inflation. Other issuershave followed, so providing inflation-linkedbonds across several countries globally. Manyinvestors have traditionally increased allocationsto commodities or equities as an indirect meansof protecting their portfolios against inflation.However, inflation-linked bonds are the onlyasset class that explicitly protects againstinflation by directly compensating the holder formovements in an inflation index.
Inflation-linked bonds are an attractive assetclass for pension schemes, offering trustees aneffective long-term tool for hedging theirinflation-linked liabilities. The index-linked giltmarket has tripled in size since 2003 andrepresents around a fifth of outstanding UKgovernment debt1. Moreover, issuance isincreasingly weighted towards bonds with longermaturities, some out to 2055, to meet pensionfund demand for assets matching longer-datedliabilities.
MINIMISING RISKThe two major risks in investing in traditionalgilts are usually changes in inflation andchanges in real interest rates (ie interest ratesexcluding the inflation rate). Upward moves ineither inflation or rates are usually negative forbondholders. For investors looking to invest infixed income assets, the prospect of higherinflation has always tended to be a concern.However, inflation-linked bonds counter thisconcern by allowing investors to hedge against
that inflation risk.Inflation-linked gilts provide inflation
protection through a change to the value of thebond based on changes in the inflation rate asmeasured by the Retail Prices Index (RPI) (SeeEconomic Concept Masterclass – Jan/Feb2010). There are two different types of index-linked gilts – ‘8 month-lag linkers’and ‘3month-lag linkers’. ■ 8 month-lag linkers: The original type of
index-linked gilt launched in 1981. Theinflation rate used for each coupon, orinterest, payment on these bonds is based onthe inflation data from eight monthspreviously. The inflation uplift to the principalis included in the price of the bond.
■ 3 month-lag linkers: Introduced in 2005 to provide investors with inflation-linked UKgovernment bonds broadly in line with themethodology used for other inflation-linkedgovernment bonds issued by governmentsglobally. The rate on the bond is based on theinflation data available three monthspreviously, and the indexation of both couponand principal is calculated separately from theprice of the bond
THE REAL YIELDThe yield of an inflation-linked gilt is oftendescribed as the real yield, or the yield tomaturity in excess of the presumed inflationrate. For instance, a bond with a real yield of0.33% is expected to return 0.33% aboveinflation if held to maturity. Interestingly, withthe current low yield levels for shorter maturityconventional gilts, some shorter maturityinflation-linked gilts have a negative real yield.
This edition of Trustee Masterclass explains the role of inflation-linked government bonds in pension investment
UK INFLATION-LINKED GILTS
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ENGAGEDT H E T R U S T E E M A G A Z I N E
in association with
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This implies thata bondholderneeds a certainlevel of inflationjust to break evenand any excessreturn thereafterwould be drivenby furtherinflation.
BREAKEVENINFLATION SPREADAs inflation-linkedbonds largelydiffer fromconventionalbonds throughtheir inflationprotectioncharacteristics, the relative value between thetwo types of bond is determined by the price ofthat inflation protection. This is known as thebreakeven inflation spread. The spread is thedifference between the yield on conventionalgilts and the yield on inflation-linked gilts ofcomparable maturities. This could be regardedas the market’s expectations of the annualisedfuture inflation rate.
Many investors make asset allocationsbetween gilts and inflation-linked gilts using thebreakeven spread between their yields as ameans of comparing the attractiveness of oneagainst the other. Given the long-term nature oftheir liabilities, pension schemes often use the30-year breakeven spread for this purpose. Thebreakeven spread for 30-year bonds can bethought of as the ‘cost’ of hedging a scheme’sliabilities from the RPI inflation rate over thefollowing 30 years using inflation-linked gilts.Figure 1 shows how the cost of hedging againstinflation can vary considerably.
CONCLUSIONInflation-linked bonds have a significant role to
play in asset allocations designed to hedgepension scheme assets against inflation risks.With interest rates at historic low levels inmany countries and some concerns overgrowing inflationary pressures, there isincreased focus from many investors inconstructing portfolios for a period of higherinflation. Annual inflation-linked bond issuancehas been over a fifth of government bondissuance in recent years. Further, as a growingproportion of the index-linked gilt issuance is oflonger-dated maturity, the bonds should bemore attractive to pension schemes looking forlong-term inflation hedging opportunities. ■1 Source: The Debt Management Office
Issued by BlackRock Investment Management (UK) Limited,authorised and regulated by the Financial Services Authority.Registered office: 33 King William Street, London, EC4R 9AS. Tel:020 7743 3000.Registered in England No.2020394. For your protection telephonecalls are usually recorded. BlackRock is a trading name ofBlackRock Investment Management (UK) Limited. This material isfor distribution to Professional Clients (as defined by the FSA Rules)and should not be relied upon by any other persons. The materialprovided is based on data as of 1 November 2010 and is providedfor informational purposes only. The information and opinionscontained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are notnecessarily all inclusive and are not guaranteed as to accuracy.©2010 BlackRock, Inc., All Rights Reserved.
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Source: The Debt Management Office
Figure 1: Price of hedging pension scheme liabilities against inflation
UK 30-year gilt yield
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