April 5 (Bloomberg) -- The U.K. pension funds of Royal Bank of Scotland Group Plc, aerospace components maker GKN Plc and the London Pensions Fund Authority have bought inflation-linked bonds and derivatives to limit the impact of salary and price increases in their defined-benefit obligations.
RBS purchased 2.9 billion pounds ($4.4 billion) of notional inflation swaps and 1.1 billion pounds of inflation-linked gilts last year to hedge its 25.6 billion-pound defined-benefit pension fund, according to its annual report published on March 27. GKN increased holdings of inflation-linked securities and swaps to 1 billion pounds in 2012, according to a Feb. 26 statement to analysts.
The purchases highlight the demand that may have contributed to a recent increase in the prices of inflation-linked gilts and derivatives. Attempts by the government and Bank of England to stimulate the flagging U.K. economy indicate a higher tolerance for inflation, prompting pension funds to consider additional hedging to protect returns.
The U.K. 10-year break-even inflation rate, a gauge of market expectations derived from the yield difference between regular and index-linked gilts, rose to 3.37 percent on March 14, its highest level since September 2008.
The rate indicates that average U.K. inflation would need to exceed 3.37 percent per year over the next 10 years for index-linked bonds to outperform nominal gilts.
Retail-price inflation, used by the U.K. government to calculate the returns on index-linked gilts, slowed to 3.2 percent in February from 3.3 percent in January, the Office for National Statistics said on March 19.
“Following the adoption of a more liability-driven approach we’ve decided to extend interest rate and inflation hedging across the entire fund,” Mike Taylor, chief executive of the 4.5 billion-pound LPFA said in an interview. “Our immediate priority is to limit inflation risk.”
The LPFA had previously limited hedging to the 1.5 billion pound part of the fund that paid pensions to existing retirees. The fund hadn’t yet decided the extent of its additional hedging, Taylor said.
An increase in U.K. inflation of just 0.25 percent would add 1.1 billion pounds to RBS’s pension liabilities, according to its annual report.
“Swaps are part of the management of the inflation and interest rate sensitivity of the Main scheme liabilities,” RBS said in its annual report. “The majority of swaps are with The Royal Bank of Scotland Plc and National Westminster Bank Plc.”
The investment decisions of the RBS Group Pension Fund are the responsibility of the RBS Pension Trustee Ltd., Linda Harper, a spokeswoman for RBS, wrote in an e-mailed statement.
Robert Waugh, chief investment officer of the Trustee company, declined to comment.
GKN said on Feb. 26 that it hedged 40 percent of the liabilities of its 2.66 billion-pound pension fund last year.
“Pension actions and de-risking continue to be a key focus,” GKN’s Chief Financial Officer William Seeger said on a Feb. 26 earnings call. “In the U.K., we have increased inflation hedging to around 40 percent of liabilities with inflation capped at 3 percent.”
GKN said it hedged five-, 10- and 15-year inflation using a combination of index-linked gilts and swaps. The company used the Netherlands-based specialist manager Cardano BV to execute the inflation-swap transactions with a number of dealer banks.
The LPFA currently uses Bank of New York Mellon Corp.’s subsidiary Insight Investment to manage its derivative hedging, and was likely to extend Insight’s mandate, Taylor said.
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