Britain’s Inflation Benchmarks Obscured by Distorted Gilt Market

This week’s sale of inflation-linked bonds in the U.K. will offer a chance to scrutinize the worst-performing major market for such securities. Just don’t expect much insight into the retail prices they’re tied to.

Britain’s linker market has been bent out of shape by declining sales of the securities and a thirst from pension funds to own them in order to match their long-term liabilities. As fixed-income markets came under pressure this quarter, the bonds’ heightened sensitivity to yield changes exacerbated losses, further distorting their relationship with the underlying inflation outlook.

Those market dynamics may determine the success of the sale more than the potential for quicker price growth. The Debt Management Office plans to sell the new 30-year bond, whose payouts are linked to the U.K.’s Retail Price Index, through banks, with a coupon of 0.125 percent.

“This is more about liability hedging, rather than valuation,” said Richard Kelly, head of strategy at Toronto Dominion Bank in London, one of 21 gilt primary dealers that trade directly with the debt office. “If you are an opportunistic investor, there is probably nothing saying this bond is going to offer a great value.”

Wage Growth

The sale is taking place amid signs that slack in the economy is beginning to be used up, with wages growing at their fastest pace in almost four years and the jobless rate at its lowest since 2008. The Bank of England sees consumer-price inflation, currently near zero, picking up this year and returning to its 2 percent target by mid 2017.

That doesn’t necessarily bode well for U.K. linkers because other international markets may seem more attractive.

According to a gauge known as duration, Britain’s index-linked debt is the most sensitive to an increase or decrease in yields, making it more risky to own. The measure is more than 14 for U.K. linkers compared with about 7.5 for U.S. Treasury Inflation-Protected Securities and less than 5 for German securities, according to Bank of America Merrill Lynch indexes.

The duration metrics indicate that if the global bonds selloff persists, similar moves in yields will trigger greater losses on British securities.

“Investors with a global mandate will probably favor U.S. TIPS,” said Jorge Garayo, a fixed-income strategist at Societe Generale SA in London.

Fortunes Reversed

While U.K. inflation-protected bonds held up in the first quarter, when signs that global economic growth was losing momentum boosted bonds, they fell back as yields started rising in the second quarter in anticipation of the Federal Reserve’s interest-rates lift-off.

The gilts lost 0.5 percent year-to-date while their counterparts in the U.S. and Germany gained 0.4 percent and 0.7 percent. Canadian linkers returned 2.8 percent.

Even then, the U.K.’s existing 30-year index-linked bond is yielding minus 0.66 percent, the lowest among its developed-market peers, leaving the outlook for inflation as implied by its break-even rates close to the highest levels in nearly a year. U.K. sales of bonds via banks typically take place on Tuesdays.

A possible support for index-linked gilts is coming from supply of the securities, which has dropped to 31 billion pounds ($49 billion) this year from 39 billion pounds in the fiscal year starting in April 2011. The trend may continue as Britain’s budget deficit shrinks, SocGen’s Garayo said.

The 30-year break-even rate, the yield difference between nominal and index-linked bonds, rose to 3.45 percentage points on June 18 from 2.96 percentage points in January. That’s the highest since July on an end-of-day basis.

“The long end of the U.K. inflation bond market looks quite expensive,” said John Stopford, head of fixed income at Investec Asset Management Ltd. in London. “This is not an area we are particularly interested in. Demand is likely to come mostly from traditional buyers such as pension funds.”

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