On 11 October, the Bank of England took an unusual step. Having announced an intervention in the gilt market the day before, it suddenly doubled down and pledged that it would buy up to £5bn of index-linked gilts daily for a week. The move came after yields on 10-year linkers briefly shot above 4.4%.
The move appeared successful. Not only did yields climb down, but a subsequent issuance of 50 year inflation-linked debt at the end of November was heavily oversubscribed, receiving more than £16.8bn in orders, despite offering negative inflation-adjusted returns.
The seemingly insatiable market appetite for linkers should be surprising, given their abysmal performance this year. Prices of inflation-linked debt have plunged. The iShares Index Linked Gilt Index fund is down nearly 30% year-to-date, while the S&P Inflation-Linked Gilt index shrank 32.4%. Why are linkers struggling to perform in the current inflationary environment and what are the pros and cons of using linkers as inflation protection?
Coffee and cream
The sheer endless investor appetite for inflation-linked debt is intrinsically linked to liability-driven investment (LDI)01. Inflation-linked securities were first launched by Nigel Lawson when he was chancellor for Margaret Thatcher’s government. They were designed for corporate pension schemes in an attempt to
make them more attractive compared to inflation-linked public sector pensions. But they didn’t take off until the emergence of liability-driven investing (LDI) two decades ago because they turned out to be a convenient asset to match liabilities.
By the end of 2021, more than 79% of defined benefit scheme assets were invested in bonds, of which almost half were inflation- linked, according to the Pension Protection Fund (PPF). As of November 2022, inflation linked debt accounted for 47.8% of the average bond portfolio in the PPF Universe, an increase of more than 10 % since 2012. In other words, linkers and LDI seemed to go together like coffee and cream.
Mind the duration
But there are some snags to this perfect pairing, as the Bank of England intervention in October illustrated. While linkers and conventional gilts are vulnerable to interest rises, the price of linkers tends to respond more sharply to a decrease in inflation expectations than conventional gilts. This is why the current market environment of rising real rates and falling inflation expectations has been so toxic.
Moreover, precisely because pension schemes have bought up linkers whilst reducing their equity exposure, the price of inflation-linked debt has been extremely volatile, raising the question whether they are suitable as a liability-matching asset or not. A 2018 research by Legal and General shows that over a ten year period, the prices of Linkers have been very closely correltated to the performance of equity markets.
In theory, there is still a strong case for linkers, if the debt is held until maturity argues Mike Eakins, Phoenix’s chief investment officer. This would also apply to LDI strategies. “We have long-dated inflation exposure and index-linked gilts provide a good means of protection against inflation,” he says.
There are still some challenges, such as the fact that linkers are matched to the retail price index, and some of Phoenix’s liabilities track the consumer price index. Moreover, the government’s reform of the RPI Index has significantly reduced returns on Linkers, bringing them more in line with the CPI Index. Eakins nevertheless believes that Linkers continue to offer inflation protection, provided they are being held to maturity. “If you want to cash in on your inflation exposure then their performance has been pretty volatile over the past 12 months, but they are a good fit for our liabilities,” Eakins adds.
But as September’s liquidity crunch has demonstrated, not every institutional investor may have the luxury to hold linkers to maturity. And in the event of a bond market meltdown, being a forced seller of linkers could be a lot more painful than being forced to sell conventional gilts. Between the 22nd and the 27th of September, the S&P Index Linked Gilt Index fell by nearly 100 basis points. This may have been one of the reasons for the Bank of England’s decision to buy linkers.
It may also be why some final salary schemes are increasingly considering other forms of inflation hedging, predicts Alan Pickering, president of Best Trustees. “People will be returning to the basics in how we deal inflation. “Will it be through index-linked government stock or will there be other asset classes, perhaps infrastructure and others that have inflation protection without the shock to nominal values?” he says.
Breakeven inflation rate
Whether linkers will pay off over the longer run depends on the key question on investors’ minds for 2023: has inflation peaked or will it remain as high? If inflation does fall back to Bank of England target levels over the next two years, as the central bank predicts, holders of linkers may not benefit. But inflation continues to rise, holding linkers till maturity might pay off. The market seems to think so, judging by investor demand for new linker issuances. A Debt Management Office auction of £700m worth in index-linked gilts with a ten year maturity drew more than £2bn in orders.
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