2020 could be momentous for the UK index linked gilt market – and not in a good way.
The UK Government has undertaken a consultation into the calculation and use of the Retail Price Index (RPI) with particular reference to index linked gilts, the effect on public finances and the integrity of the statistical system.
This will potentially have a major effect on the market, but there are so many uncertainties about the outcome, that for the moment the market remains calm.
What is the problem with the RPI and what does this mean for index linked gilts? Firstly, the UK National Statistician has recommended that the RPI calculation has statistical shortcomings and should be aligned with a different measure of inflation, the CPIH (Consumer Price Index including owner occupier's housing costs) over time.
Coupon and redemption proceeds of index linked gilts are currently linked to the level of the RPI. A change of index therefore will change the size of future cash flows expected from the bonds and thus the price of the bonds.
The RPI has consistently risen at a faster pace than the recommended index (CPIH) so to align the indices will reduce the value of future cash flows and the price of the bonds will fall.
The longest dated bonds will suffer the biggest price falls. It is estimated that the market price of the longest bond in the market, maturing in 2068, could fall as much as 30% should the consultation rule the change should occur.
However, the process is beset by uncertainty. The consultation was due to start in January 2020 and report by the end of the current financial year, but this timeline has slipped already to March with results by the end of April.
The timescale for any change should it occur is also unknown, the Chancellor has already ruled out any change before 2025.
There is also the question of compensation; would investors be compensated and, if so, by how much? Would it apply to those with derivatives linked to the RPI too? What would happen to those who receive payments linked to RPI, would they be included?
It is because of these uncertainties over both timeline and detail that all remains calm in the UK index linked market. But do not expect it to last.
Sandra Holdsworth is head of rates at Kames Capital
• Index linked bonds can provide an effective hedge against inflation in the future
• Pension demand for the sector remains strong
• A change in RPI calculation methods will affect the value of the bonds negatively
• The uncertainty regarding the Government Consultation process will deter investors