Investors uncertain about merit of UK CPI: linker issuance

LONDON: British proposals to issue government bonds linked to consumer price inflation, alongside those pegged to a home-grown price gauge, may please some gilt investors but have also aroused concerns that a rival linker market could damage liquidity.

The UK currently issues inflation-protected bonds that are linked to the long-established national Retail Price Index.

But a shift in government policy to use the CPI to calculate changes in state benefits and public pensions -- with an option for private pension schemes to do the same -- has led to growing calls for CPI-linked bonds.

Using the CPI to decide increases in benefits and index-linked gilts is expected to deliver significant cost savings for the government, because this inflation measure has tended to be around 1 percentage point below RPI.

The CPI measure was introduced to give European Union countries a common inflation gauge and the Bank of England has adopted it as the gauge for its inflation target.

Britain's Debt Management Office has just finished consulting with investors on whether to issue CPI linkers.

But some fund managers are concerned that issuing an additional type of bond could hit liquidity in the RPI-linker market -- worth around 287 billion pounds ($440 billion), or 21 percent of all gilts in issue.

Since pension funds will not be legally obliged to change the indexation of private pensions to CPI from RPI, there are also conflicting views about demand for a new type of linker.

"We currently see little demand from our client base for CPI-linked bonds relative to RPI-linked bonds in order to hedge their pension liabilities," said Trevor Welsh, fund manager at Aviva Investors. "We are also concerned that the introduction of CPI issuance, which would need to be a substantial proportion of new issuance, would significantly reduce liquidity in the RPI market. This in turn would raise the overall cost of hedging."

HEDGING COSTS

But David Dyer, a portfolio manager at Axa Investment Managers which holds almost 10 billion pounds of index-linked gilts, thinks gilts linked to the more internationally used CPI would attract investors.

"Benchmarked investors whose benchmarks incorporated CPI issues would also provide automatic demand," he said.

He reckons that CPI linkers could reduce the hedging cost of pension funds that currently have to use RPI-linked bonds to match CPI-linked assets, although he notes it could take time for the market to develop.

By contrast, Aviva -- which says it is a major investor in gilts -- argues that a rival to the existing RPI-linker market could raise the cost of inflation-hedging for pensions schemes.

"The only way to avoid an adverse impact would be to increase the proportion of overall inflation-linked issuance within the total issuance structure in order to satisfy the continuing demand for the product," Welsh said.

Issuing inflation-protected bonds can be costly for governments, however, and so Britain is unlikely to want to raise linker issuance to satisfy two separate markets.

Aviva's Welsh also suggests the government should hold back from linking gilts to CPI until Britain's Office for National Statistics finishes developing new housing cost indices, reflecting Britain's high proportion of owner-occupiers.

"We would certainly prefer to delay such action until questions over the inclusion of housing costs within the CPI are agreed and implemented," he said.

"This will mean that any bonds will be based on an index likely to remain the officially recognised index and be used over the expected life of the bonds."

The statistics programme is due to be completed in September 2012, but it is likely to be some time before the data is included in the headline CPI measure.

Copyright Reuters, 2011