Bonds linked to U.K. inflation are beating all but one of their developed-market peers this year, a sign investors see price increases accelerating from the slowest pace since 2009 as the economy gathers strength.
The securities, known as linkers and designed to insulate holders from fluctuations in the cost of living, returned 4.7 percent this year, compared with a 3.1 percent gain from U.S. Treasuries Inflation Protected Securities, or TIPS, according to Bank of America Merrill Lynch indexes. Similar bonds in the euro region gained 3.5 percent.
With the International Monetary Fund forecasting Britain’s economy will grow the most among the Group of Seven nations this year, a drop in the annual consumer-price index to below the Bank of England’s 2 percent goal may prove only temporary. That’s a boon to investors in U.K. linkers, who benefited from four years of above-target inflation that ended in December.
“Disinflation concerns that have plagued the euro zone and to a lesser extent the U.S. are not really evident in the U.K.,” Shahid Ladha, head of U.K. rates strategy at BNP Paribas SA in London, said in comments confirmed on April 16. “Inflation should be higher in the U.K. as growth is rebounding at a faster pace.”
Canada’s linkers, the best performers this year, returned 7.2 percent after central bank Governor Stephen Poloz said he would view faster inflation this year as temporary and seek to reduce slack in the economy. An aggregate index of euro-area securities trailed behind Britain’s as lower returns from French and German debt countered a rally in Italy.
Inflation has been below the Bank of England’s goal for the past three months and fell to 1.6 percent in March. A rebound, coupled with falling unemployment, may diminish Governor Mark Carney’s case for keeping the benchmark interest rate at a record-low 0.5 percent. It would also risk reigniting a squeeze on consumers just as wage increases catch up with CPI, having trailed the inflation rate since 2010.
U.K. index-linked gilts are also winning thanks to demand from pension funds seeking to meet future commitments, according to Michael Amey, a money manager at Pacific Investment Management Co., which oversees the world’s largest bond fund.
Retirement funds are buying the bonds after an improved financial position encouraged them to switch out of stocks so they can make revenue more predictable by reducing vulnerability to price swings and inflation. The yield on 20-year index-linked gilts, typically owned by the funds, has dropped by 16 basis points since the end of last year to minus 0.06 percent at 1:30 p.m. London time.
Bolstered by the performance of stocks -- the MSCI All-Country World Index rose about 15 percent in the past 12 months -- U.K. retirement plans have enough assets to cover 94.3 percent of their future commitments as of March, according to the Pension Protection Fund. That’s an increase from 82.6 percent a year ago.
“The rally has improved funding positions of U.K. pension schemes, which will use this opportunity to reduce risk in their portfolios,” Amey said in a phone interview on April 17. “And risk-free bonds for them to buy are long-dated U.K. linkers.”
The IMF raised its forecast for the U.K.’s economic growth on April 8 for the second time this year, predicting Britain will have the fastest expansion among developed nations. Growth will be 2.9 percent in 2014 and 2.5 percent next year, the IMF said. That compares with a January forecast of 2.4 percent and 2.2 percent.
The IMF also said the recovery remains uneven and said the Bank of England should keep monetary policy accommodative. Five years ago, Britain was mired in the biggest slump since World War II, with output shrinking 7.2 percent in the aftermath of the global financial crisis.
While growth is accelerating, for now, inflation is doing the opposite. The rate of consumer price increases last month dropped from 1.7 percent in February, the Office for National Statistics said on April 15, taking it to the lowest since October 2009.
Another fillip for U.K. inflation bond prices is that they are more sensitive to an increase or decrease in yields, according to a technical measure known as effective duration.
The reading was 12.9 for U.K. linkers compared with 7.5 for U.S. TIPS and 3.6 for comparable German debt, according to Bank of America Merrill Lynch indexes. That indicates that when yields on U.K. and U.S. index-linked bonds fall at the same pace, the British securities will outperform.
“Duration is a very important factor that explains why U.K. index-linked bonds are doing well,” said Michael Pond, the New York-based head of inflation-market strategy at Barclays Plc. “While we see an upside risk, we expect U.K. inflation to be moderate. Within our global index-linked bond index, U.K. linkers have the longest duration exposure.”
BNP Paribas estimates that duration accounted for around half of the comparatively better performance this year.
While consumer-price inflation, the basis for the Bank of England target, dropped in the past six months, the gap between that gauge and a measure including house prices has widened.
Retail-price inflation, or RPI (UKRPYOY), which determines payouts on U.K. index-linked bonds, was 2.5 percent in March. That’s nearer the 12-month average of 2.9 percent than CPI, which had a mean of 2.3 percent.
House prices rose 9.1 percent in February from a year ago, the most since June 2010, the ONS said on April 15. London prices surged 17.7 percent, the biggest increase since July 2007.
Pimco is avoiding long-maturity U.K. index-linked bonds because they are “expensive,” Amey said. The company prefers five- and 10-year linkers due to the outlook for RPI.
“Even though CPI is coming down quickly, RPI will hold up better because of the housing component,” Amey said.
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