Cameron Saving Face at $11 Billion Linker Cost: Credit Markets

U.K. prime minister David Cameron
David Cameron, U.K. prime minister, seen here in a Nov. 19, 2012 photo, said Jan. 6 on BBC Television that it was important to convince international investors to keep buying gilts, after his government implemented spending cuts to control the deficit in the deepest austerity drive since World War II. Photographer: Simon Dawson/Bloomberg

U.K. Prime Minister David Cameron is finding bond-market credibility doesn’t come cheaply.

The nation’s statistics agency decided yesterday to leave a formula for calculating the inflation rate known as the retail price index unchanged, meaning the government will have to pay as much as 7 billion pounds ($11.3 billion) more a year to investors by 2016-17, according to Capital Economics Ltd.

Investors from Pacific Investment Management Co. to Baring Asset Management had said they were holding back on purchasing inflation-protected gilts because of the proposals, which risked undermining Britain’s credibility as a debt issuer and helped to make 2012 the worst year for the bonds since 2001. Yields tumbled to record lows yesterday after the decision.

“There was a risk that the U.K. would start to lose its safe-haven status because you had a number of messages all questioning how sacrosanct the U.K. bond market was,” said Michael Amey, a London-based money manager at Pimco, which runs the world’s biggest bond fund. “By leaving the RPI calculation unchanged I think they’ve made a step towards reinforcing the U.K.’s low-yield status.”

The 220 billion-pound market for inflation-protected gilts surged, with the 10-year yield falling 34 basis points, or 0.34 percentage point, to minus 0.96 percent, and touching an all-time low of minus 0.99 percent.

Rally Extension

The rally extended to corporate bonds, with the price of Network Rail’s 3.425 billion pounds of 1.125 percent inflation-linked debt due 2047 jumping 7.29 to 124.48, a six-month high.

“A material change would have put pressure on U.K. assets so with that cloud lifted I think it is moderately helpful,” Pimco’s Amey said.

Britain’s Cameron, and Chancellor of the Exchequer George Osborne, have sought credibility in the bond markets as Europe’s debt crisis pushed Greece, Ireland and Portugal to seek international aid and sent yields on Spanish and Italian securities to euro-era highs.

The prime minister said as recently as Jan. 6 on BBC Television that it was important to convince international investors to keep buying gilts, after his government implemented spending cuts to control the deficit in the deepest austerity drive since World War II.

Default Swaps

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. climbed. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, increased 0.9 basis point to a mid-price of 86.9 basis points as of 11:35 a.m. in New York, according to prices compiled by Bloomberg. The benchmark has climbed from 84.9 on Jan. 7, the least since Sept. 14.

The measure typically rises as investor confidence deteriorates and falls as it improves. The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, increased 0.18 basis point to 13.87 basis points as of 11:35 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Bonds of Bank of America Corp. are the most active dollar-denominated corporate securities today, accounting for 6.8 percent of the volume of dealer trades of $1 million or more as of 11:36 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Price Changes

Yesterday’s gains in Britain’s so-called linkers mark a turnaround after Bank of America Merrill Lynch’s U.K. Inflation-Linked Gilt Index tumbled 3 percent this year through Jan. 9 on concern the government would change the way it calculates the retail price index in order to address a gap with its consumer price index. The Merrill Lynch gauge rose 0.8 percent in 2012.

The widening difference between RPI and the consumer-price index is due to differences in the mathematical formulae used to calculate price changes. This disparity, known as the formula effect, was stable at about 0.5 percentage point until early 2010, CPAC said in its 2012 annual report. The gap widened to 1 percentage point after the ONS in February 2010 changed the way it calculates clothing prices in the RPI.

‘Significant Value’

The retail price index has “significant value” for investors, National Statistician Jil Matheson said yesterday. The government plans to continue selling new inflation-linked gilts tied to the gauge following the decision, Treasury minister Sajid Javid said.

“What is very noticeable is the opprobrium that fund managers heaped on the whole process,” Marc Ostwald, a rates strategist at Monument Securities Ltd. in London said, in an e-mailed note. “Osborne now needs to find somewhere else to scrimp and save.”

The U.K. 10-year break-even rate, or the difference in yield between conventional gilts and inflation-protected securities, had its biggest gain since Bloomberg began collecting the data in 1992, widening 41 basis points to 306 basis points.

The decision taken by the Office for National Statistics on the inflation measure may help the U.K. to maintain its Aaa rating, according to Scott Phillips, an analyst at Moody’s Investors Service.

Outlook Changes

“While the ONS’s decision not to implement any of its proposed changes is surprising, Moody’s views the development as positive for the sector and reinforces its assessment of the stability and predictability of the U.K. regulatory framework, which includes the political environment in which companies operate,” he said in a report yesterday.

Standard & Poor’s lowered its outlook on Britain’s top credit grade last month to “negative,” citing weak economic growth and a worsening debt profile.

Rating cuts don’t always signal that bond prices will fall. French 10-year yields have dropped more than 100 basis points, or 1 percentage point, in the past year despite the country losing its top rating with S&P and Moody’s.

About half the time, government bond yields move in the opposite direction suggested by new ratings, according to data compiled by Bloomberg in June on 314 upgrades, downgrades and outlook changes going back to 1974.

Convincing investors to buy U.K. government debt is ultimately more important than whether ratings companies downgrade gilts, Cameron said on BBC Television’s “Andrew Marr Show” on Jan. 6. “Britain needs low interest rates.”

International investors added to holdings of gilts for a 10th-straight year in 2012, according to monthly data on the Bank of England’s website.

“At least the Chancellor will avoid the risk of tarnishing his credibility through another ‘fudge’ of the figures,” Vicky Redwood, an economist at Capital Economics in London, wrote in an investor report. Still, without the savings that could have been made by changing the RPI formula, “the government is certainly the biggest loser from the decision,” she wrote.

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