Pacific Investment Management Co.’s Michael Amey says Britain’s review of its retail-price index calculations is threatening the gilt market’s reputation as a haven for investors.
The U.K.’s 266 billion pounds ($431 billion) of inflation-linked bonds, which pay investors based on changes in the retail-price index, are underperforming conventional securities amid concern adjustments to the gauge will dent returns. The 30-year break-even rate, the difference in yield between nominal and index-linked bonds, narrowed to an eight-year low today. Alterations to the index may cut retail-price inflation by as much as 0.9 percentage point and lower government expenses, according to analysts at Capital Economics.
“Changing the goalposts on the inflation measure used in U.K. linkers would be a very big event,” Amey, a portfolio manager at Pimco, said in an interview in London yesterday. “If there was a wholesale adjustment to the RPI that would be a potential risk to the U.K.’s safe-haven status because if you start to change the rules for the bond market, then the bond market will naturally demand a higher yield.” Pimco manages the world’s biggest bond fund.
While index-linked government debt is tied to retail prices, the Bank of England sets its benchmark interest rate based on consumer-price inflation, which has been lower than retail-price inflation on average for the past two decades. The independent Consumer Prices Advisory Committee said on Sept. 18 there is “sufficient evidence to consider change” to inflation calculations and it’s examining “any unjustifiable formula effect gap” between the two measures.
The 30-year break-even rate narrowed to as little as 2.75 percentage points today, the least since December 2003. It was at 2.8 percent at 5 p.m. in London, having fallen 62 basis points from this year’s high of 3.42 percentage points set on April 2.
The market is reacting to “uncertainty” about what the changes may entail, Robert Stheeman, chief executive officer of the U.K.’s Debt Management Office, said in an interview. “We have seen a decline in relative value in linkers versus conventionals. Break-evens have sold off.”
U.K. index-linked securities have made a 4.3 percent loss this year, according to indexes compiled by Bank of America Merrill Lynch. Conventional gilts have returned 3.4 percent in the same period. Last year, inflation-protected securities returned 21 percent versus 17 percent for nominal bonds.
Declines may be a result of the “potential for changes and the uncertainty that brings with it,” Stheeman said yesterday in London. “I would like to think that once the market knows the outcome, which is not something I do at this stage, that uncertainty will be removed.”
The so-called “formula effect” has meant the retail price index was about half a percentage point higher than CPI until January 2010, when the gap between the two widened to about 1 percentage point, according to calculations by Barclays Plc economists Simon Hayes and Alan James in a Sept. 18 note.
The National Statistician will publish a consultation document on Oct. 8 and responses are due by Nov. 30. The Consumer Prices Advisory Committee advises the Statistics Authority on potential changes to the inflation measures.
“The market seems to be assuming the final result from this CPAC consultation is the elimination the formula effect,” said Kari Hallgrimsson, head of European inflation trading at JPMorgan Chase & Co. in London. “If you bought index-linked gilts under the presumption that you are going to get RPI,” then “you might feel disappointed if they change the formula.”
The government may save around 7 billion pounds a year by 2016-2017 by reforming the U.K.’s inflation indexes, with holders of index-linked bonds set to be the “biggest losers,” Capital Economics’s Roger Bootle, a former adviser to the U.K. Treasury, wrote in a report two days ago.
Speculation that possible changes are designed to reduce the government’s index-linked payments are “rather farfetched, given the clear independence of those making the proposals,” Stheeman said.