UK index-linked bonds are popular again, but should they be?
Last month the Chancellor of the Exchequer responded to proposals from the UK Statistics Authority (UKSA) that the Retail Prices Index (RPI) should be reformed. The UKSA had recommended that RPI be aligned with the Consumer Prices Index including owner occupiers’ housing costs (CPIH). That would leave RPI significantly lower, between 0.5% and 1.0%.
Though the Chancellor refused to agree to such a change before 2025, given the time that RPI users would need to adjust, he did agree to a consultation with the UKSA beginning in January 2020. Crucially, he also confirmed that the Chancellor’s consent would no longer be needed to make such a change after 2030.
The news rocked UK index-linked bonds at the time, and yet the market has since entirely recovered as if nothing ever happened. Chiefly responsible has been liability-driven investment from pension funds. They fear a major currency shock in the wake of a ‘no deal’ Brexit which would result in surging inflation. We think they’ve made a huge mistake.
UK index-linked bonds have become inordinately expensive. If you were to sell UK conventional gilts to purchase hedged French equivalents, you would receive a pick-up in yield of around 50 basis points (bps). Perform the same trade in the index-linked space and you will receive an enormous yield increase of 250bps.
Consider also the long-term outlook for inflation. Any Brexit outcome that avoids the UK leaving without a deal should be supportive for sterling, driving inflation down. But even in a ‘no deal’ scenario, the ensuing inflationary surge would be time-limited due to base effects. Meanwhile, the substantial downward revisions to future RPI would exert long-term downward pressure on inflation.
Moreover, we think that the RPI reform will definitely go ahead, even if it takes 10 years to do so. As a representation of reality, the current calculation of RPI is horrific. The only reason that it hasn’t been reformed already is that it faces immense political opposition. Once the Chancellor relinquishes authority, that obstacle will be gone and accuracy can kick in.
As long-term investors, we have positioned our funds in line with the long-term inflationary trends. There is currently a serious mispricing of UK index-linked assets and this has provided us with a fantastic opportunity to achieve a significant pick-up in yields by selling shorter-dated real yields in the UK to buy hedged global equivalents.
In the UK…sale now on!
Past performance is not a reliable indicator of future results. 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. Portfolio holdings are subject to change, for information only and are not investment recommendations.