Gilt corner: demand for linkers will continue, regardless of the CPI number


Paul Rayner, Head of Government Bonds

13 November 2017

The last couple of weeks have muddied the waters of a steady rise in UK break-evens over the summer and autumn months, which ticked higher in line with a gently rising oil price. The only real bumps in the road up until now were index-linked syndications in July and November, market events where bonds tend to sell off in expectation of fresh supply and rally after the event as buyers lock down their new positions.
The latest syndication for 2048 maturities took place last week and, as expected, the market sold off into this syndication and we placed a curve-flattening trade in many of our portfolios, selling shorter dated index-linked bonds and buying longer duration bonds (along with an allocation from the new syndication), in expectation of a rally. 
Despite a dearth of UK inflation data and predictions of a peak, the rally in linkers has been particularly sharp this time round, thanks to a number of technical factors. Last week might not have been the largest ever syndication in terms of bond issuance but it smashed through all previous order book records, with £25 billion of demand for index-linked bonds.
When the Debt Management Office is faced with such unprecedented demand, the allocations they make available to a range of interested parties is reduced. While a number of traditional buyers of index-linked bonds such as liability driven investors, pension investors and traditional asset managers (such as ourselves) received around 40% of the allocation applied for, many of the market makers only received about 1% of what they had ordered.
And while this was bound to place a squeeze on liquidity for the new bonds, this has been vastly exacerbated by an index event taking place in two weeks’ time, as various UK Index Link Indices  see a duration extension of almost a year, including the all stock, over 5 year and over 15 year.
With so few market makers holding bonds and with so many passive funds looking for longer duration assets to match these benchmark adjustments, we’re expecting to see break-evens to keep pushing steadily higher into this index event, regardless of the Consumer Price Index (CPI) number being published on Tuesday.

The last couple of weeks have muddied the waters of a steady rise in UK break-evens over the summer and autumn months, which ticked higher in line with a gently rising oil price. The only real bumps in the road up until now were index-linked syndications in July and November, market events where bonds tend to sell off in expectation of fresh supply and rally after the event as buyers lock down their new positions.

The latest syndication for 2048 maturities took place last week and, as expected, the market sold off into this syndication and we placed a curve-flattening trade in many of our portfolios, selling shorter dated index-linked bonds and buying longer duration bonds (along with an allocation from the new syndication), in expectation of a rally. 

Despite a dearth of UK inflation data and predictions of a peak, the rally in linkers has been particularly sharp this time round, thanks to a number of technical factors. Last week might not have been the largest ever syndication in terms of bond issuance but it smashed through all previous order book records, with £25 billion of demand for index-linked bonds.

When the Debt Management Office is faced with such unprecedented demand, the allocations they make available to a range of interested parties is reduced. While a number of traditional buyers of index-linked bonds such as liability driven investors, pension investors and traditional asset managers (such as ourselves) received around 40% of the allocation applied for, many of the market makers only received about 1% of what they had ordered.

While this was bound to place a squeeze on liquidity for the new bonds, this has been vastly exacerbated by an index event taking place in two weeks’ time, as various UK Index Link Indices  see a duration extension of almost a year, including the all stock, over 5 year and over 15 year.

With so few market makers holding bonds and with so many passive funds looking for longer duration assets to match these benchmark adjustments, we’re expecting to see break-evens to keep pushing steadily higher into this index event, regardless of the Consumer Price Index (CPI) number being published on Tuesday.

Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.