2. Contents
Executive Summary
UK Inflation-Linked Markets
4
Inflation-Linked Bonds vs Inflation-Linked
Liabilities
6
Alternative Sources of Inflation-Linked Assets
7
About the Authors
8
Further Information and Disclaimer
January 2013
3
9
For Institutional Investors
2
3. Executive Summary
Inflation-linked bond markets have expanded
Inflation-linked outstanding issuance has quadrupled since 2005. Inflation-linked bonds in issuance
amount to £235bn, with roughly £200bn in inflation-linked gilts and £35bn of corporate issuance.
The liquidity on the long-end has improved.
But not enough to match pension schemes’ appetite
This should be great news for pension schemes as they establish de-risking strategies and seek
matching assets. However, the inflation-linked market growth is not enough to match the inflationlinked part of the £1,200bn UK pension schemes’ liabilities. This mismatch between demand and
supply is not likely to revert soon, pushing the real yield at the long-end lower.
Alternative sources of inflation-linked assets
In order to avoid this shortage of supply, pension schemes should compare index-linked gilts
opportunities to other solutions available in the Liability Driven Investment space. There are often
other ways to hedge inflation risk at a lower cost and still benefit from credit and illiquidity premia.
January 2013
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4. UK Inflation-Linked Markets
From 1981 to now, the UK inflation-linked market has expanded from £1bn to £189bn nominal as of
November 20121.
Of all inflation-linked bonds issuers, the UK has the biggest proportion of its marketable debt being
inflation-linked (only Sweden seems to compete, but with a market ten times smaller). About 22% of
the total gilt market is inflation-linked. In comparison, the Treasury Inflation-Protected Securities
(TIPS) market amounts to $736bn, but only represents 7.5% of their marketable debt (including bills,
notes and bonds)2.
Figure 1: Size of the gilt market
1,000
900
800
700
£ billion
600
500
400
300
200
100
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Conventional (nominal)
Index-linked (nominal)
Source: UK Debt Management Office
Corporate inflation-linked bonds
In addition to inflation-linked gilts, about 70 UK companies have inflation-linked debt for a total issue
size of £35bn. This amount has almost tripled since 2005. This is dominated by the utilities sector,
where revenues are closely linked with inflationary developments.
The market is still very concentrated with the ten largest issuers representing about 65% of the total
UK corporate inflation-linked bond market:
Data are available on UK Debt management Office website http://www.dmo.gov.uk. The nominal figure for the inflationlinked gilts is non- inflation adjusted, on an adjusted basis inflation-linked gilts represents £265bn.
2 Data are available on http://www.TreasuryDirect.gov. Non- inflation adjusted; on an adjusted basis inflation TIPS outstanding
amount represents $819bn.
1
January 2013
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5. Table 1: First ten UK companies by inflation-linked bonds’ issuance
Sector
Average time to
maturity
Size
£ bn
Percentage of
corporate IL issue
Network Rail Infrastructure
32
12
33%
National Grid Gas Plc
26
2
6%
Anglian Water Service
32
1
4%
National Grid
21
1
4%
United Utility Water
35
1
4%
Thames Water Utility
37
1
4%
Severn Trent Water
40
1
2%
Channel Link
30
1
2%
Yorkshire Water
41
1
2%
Tesco Plc
13
1
2%
Source: UK Debt Management Office
UK inflation-linked bonds available by maturity
We have sorted the total par amount of both government and corporate IL bonds by 5 year buckets
and shown them in the chart below.
The long-dated inflation-linked liquidity has improved over the last seven years: the total 20yr+
inflation-linked debt represents 60% of total inflation-linked debt, whereas it represented only 34% in
2005.
Figure 2: UK inflation-linked bonds by maturity
70
60
£ billion
50
40
30
20
10
0
0-5yr
5-10yr
10-15yr
15-20yr
20-30yr
30-50yr
50yr +
Corporates
0
2
5
2
12
14
0
Gilts
28
22
24
14
59
64
0
Years to maturity
Corporates
Gilts
Source: Bloomberg, Calculations: Redington
January 2013
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6. Inflation-Linked Bonds vs. Inflation-Linked Liabilities
Based on estimates from The Pension Protection Fund (PPF) as of March 2012, UK Defined Benefit
total liabilities amount to £1,231bn; 56% of those are inflation-linked. This is about three times the
total size of the UK’s inflation-linked bond market.
Figure 3: UK inflation-linked bonds and equivalent pensions’ liabilities by maturity
180
160
140
£ billion
120
100
80
60
40
20
0
Years to maturity
UK Pensions' inflation-linked liabilities
Corporates
Gilts
Source: Bloomberg, PPF, Redington
This mismatch in supply and demand, among other factors, has pushed down long-dated UK real yield
levels as the latest results of gilt auctions show:
Table 2: Summary of last six months index-linked gilts’ issuance
Auction
date
Gilt name
Amount issued,
£ mn
Yield
Times
covered
Dec-12
0⅛% Index-linked Treasury Gilt 2024
1,130
-0.58%
2.37
Nov-12
0¾% Index-linked Treasury Gilt 2047
900
0.29%
1.75
Oct-12
0⅛% Index-linked Treasury Gilt 2024
1,649
-0.44%
2.56
Sep-12
0¾% Index-linked Treasury Gilt 2034
1,346
0.13%
1.55
Aug-12
0⅛% Index-linked Treasury Gilt 2029
4,297
-0.03%
-
Jul-12
0½% Index-linked Treasury Gilt 2050
932
0.11%
2.08
Jun-12
0⅛% Index-linked Treasury Gilt 2029
1,366
-0.11%
1.83
Source: Bloomberg, PPF, Redington
There is no apparent reason to think this trend will revert, given that 80% of pension funds have a
hedge ratio of less than 50%, and many of them have plans to move further from equities into
matching assets.
January 2013
For Institutional Investors
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7. Alternative Sources of Inflation-Linked Assets
In this context, accessing real yields through index-linked gilts may not always be the optimal solution.
The decision to enter the index-linked gilt market should come after an evaluation of current gilt yield
levels and opportunities to lock in substantial improvements along the curve.
The use of derivatives, such as swaps, can lower the cost and tailor the exposure to the pension
scheme’s need. However, given new bank capital rules, these kinds of long dated trades are
becoming more expensive for them to intermediate and, therefore, the price of derivatives is
increasing.
Another way to hedge inflation risk is using nominal corporate bonds overlaid by inflation swaps
through banks. For the same regulatory reasons, this is already becoming more costly and less
efficient and looks set to continue. In this new environment, both sides, issuers (such as utility
companies) and pension schemes, will find it more expensive to hedge via a bank balance sheet.
Therefore, pension schemes should be looking to source this supply directly.
As the cost of entering into inflation swaps with banks rises, utility companies may issue more
inflation-linked bonds and search for replacement counterparties for their existing and new inflationlinked swaps. Pension schemes should be prepared to spot good opportunities in this space.
Pension schemes now have available to them a wider choice of alternative solutions to match
liabilities’ inflation risk, and they do not need to give up the risk premium. Investing in infrastructure,
social housing or secured leases can be as efficient as inflation-linked bonds are to hedge against a
rise in inflation, but they deliver an additional premium for credit and illiquidity.
January 2013
For Institutional Investors
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8. About the Authors
We would welcome the opportunity to discuss further. Please do get in touch to find out more.
Robert Gardner
Co-Founder & Co-CEO
•
Contact:
Also in Financial News’ 100
Rising Stars (Investment
Consulting) in 2009
robert.gardner@redington.co.uk
•
Robert co-founded
Redington in 2006 to help
clients implement a clear 7
step process to full funding
Named in ai CIO’s Top 25
Investment Consultants in
the World 2012
•
•
Avid supporter of Commando
Spirit and board member of
The Catalyst Club
•
Started his career at
Deutsche Bank before
joining Merrill Lynch in their
Insurance and Pensions
Solutions Group
+44 (0) 20 7250 3416
Marina Jelesova
Analyst, ALM & Investment Strategy
•
•
Marina joined Redington
in September 2012
•
Holds an MSc degree in
Financial Markets from
EDHEC Business School
Previously worked at BNP
Paribas with a focus on
hedge fund analysis
January 2013
Contact:
+44 (0) 20 3326 7158
marina.jelesova@redington.co.uk
For Institutional Investors
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