Retail price index changes could hit 'complacent' index-linked gilt investors
Overhaul impact on 'linkers' to be assessed
Prices of long-dated index-linked gilts could see another steep fall as investor complacency sets in, but an allocation to the asset class could still benefit multi-asset portfolio managers, according to industry experts.
The UK index-linked gilts sector was the best-performing Investment Association (IA) sector in the 12 months to 31 August, with the average fund returning 19.99% as interest rate expectations began to decline.
However, gains reversed when changes to the retail price index (RPI) methodology were announced on 4 September.
UK inflation slips to 32-month low
In the month of September, so-called linkers were the worst-performing IA sector, losing an average of 1.75%.
The overhaul, expected to happen between 2025 and 2030, will bring the measure in line with the consumer price index, which includes housing costs (CPIH), lowering nominal returns from linkers, which currently see both their coupon payments and redemption values rise in line with RPI by around 0.8%.
The price of UK linkers fell around 10% on the day, with the longest-dated of all, which matures in 2068, slipping 14% to £256.
However, the majority of those losses were quickly regained, with the 2068 now changing hands for around £295.
Mark Capleton and Adarsh Sinha, strategists at Bank of America Merrill Lynch, said this suggests "investors seem confident this RPI decision will be modified or reversed; that seems complacent".
Ruth Gregory, senior UK economist at Capital Economics, calculates the net present value of the 2068 linker uprated by CPIH would be worth £224 - 24% lower than today's price. "This suggests there would be a further slump in the price if the reforms are implemented," she explained.
While admitting the potential for "disruptive RPI reform is a risk", Bertie Dannatt, investment director at Ruffer, thinks investor complacency combined with an increasing sensitivity to higher inflation is "the most compelling risk in this space".
Ruffer has around 10% of its portfolios invested in the 2068 index-linked gilt, despite its "eye-watering valuation" of a 1.9% negative real yield.
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"The reason we continue to hold this investment is because we think negative real yields in this country have the potential to become even more negative," said Dannatt.
"Imagine we move to a world where inflation in this country is - or the market expects inflation to get to - 7%, but that interest rates cannot rise above 2% because of the significant debts we have accumulated.
"The price of these bonds can increase significantly. Indeed, in this scenario, the negative real yield would move from minus 1.9% to minus 5%, which would see the price travel from a value of circa £295 today to in excess of £1,360 - an increase of four and-a-half times."
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