Why is the government reducing the supply of inflation-linked bonds?
Alongside the Chancellor's spring statement, the UK Debt Management Office announced the funding plan for 2018/19. This plan included a reduction in issuance of index-linked gilts because government agencies are concerned about the uncertainty around the long-term prospects for inflation. The Chancellor and the Bank of England ("BoE") have been talking about inflation falling back to the 2% target. Inflation falling should mean that inflation-linked bonds provide cheap funding for the government.
Firstly, we should reflect on the history of index-linked issuance. Inflation-linked bonds were first issued by the State of Massachusetts Bay as early as 1780, in this case, the inflation basket included wool, beef, corn and shoe leather. The UK was the first major government to do so and the first issue came in March 1981, at a time when Retail Price Inflation ("RPI") was at 12.6%, hence it appealed to investors worried about high inflation. With capital and income going up with the RPI, the 2% real interest rate seemed attractive despite the fact that the conventional ten year gilt yields were around 14%. As an investor in the new instrument, you would need inflation to remain above 12% to make up the difference between the 2% index linked and 14% fixed interest rate. Over the fifteen year life of that first bond, the RPI averaged 5.4% thus the bond only returned 7.4%, or about half the return for investors of a conventional bond. However, 7.4% as opposed to 14% was extremely cheap funding for the government. The first bonds were confined to institutional investors and the issue size was just £400 million but the market was quickly opened up to a wider audience and issuance grew. As long as inflation undershoots expectations, it is cheap funding for the government but if inflation rises it is a better deal for investors.
Twenty seven years later the annual issuance had risen from £400 million to £28.4 billion reducing to £21.7 billion over the next tax year. Index-linked gilts make up 26% of total outstanding debt, a much higher proportion than any other G7 country. The current yield on 10 year gilts is just 1.44% and the real yield is minus 1.63%, meaning that the implied inflation expectations are for RPI to average 3.07% over the next ten years. RPI has been running at 4.1% in the last year which has been good for index-linked investors but less so for the government. The BoE target rate is Consumer Price Inflation ("CPI") which has fewer housing costs than RPI. There has been talk of gilts linked to CPI rather than RPI but investors have understandably been less than enthusiastic about this. If the RPI/CPI relationship remains the same, and it may not, then the fall in CPI back to target would bring the RPI rate close to market pricing. This means that in this case the falling inflation rate brings the cost of index-linked debt back in line with conventional bonds rather than providing a particular benefit to the government. The decision to reduce issuance appears to be the result of a wish to remove some uncertainty from the path of future government finances. It may also be a case that with fixed interest so low why not borrow more at a fixed rate while this remains the case.
On balance, less supply will support index-linked gilt prices relative to conventional bonds. While we agree with the government that inflation is likely to fall from the present level this is priced in to the market and index-linked bonds remain attractive for balanced portfolios looking to offset inflationary risks.
Source: UK Debt Management Office and Bloomberg
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