Red views inflation-linked-bonds-issuance-and-pensions-liabilities-january-2013

Inflation-Linked Bonds Issuance and

Pensions Liabilities

January 2013

For Institutional Investors

January 2013 For Institutional Investors

2

Contents

Executive Summary 3

UK Inflation-Linked Markets 4

Inflation-Linked Bonds vs Inflation-Linked

Liabilities 6

Alternative Sources of Inflation-Linked Assets 7

About the Authors 8

Further Information and Disclaimer 9


3

Executive Summary

Inflation-linked bond markets have expanded

Inflation-linked outstanding issuance has quadrupled since 2005. Inflation-linked bonds in issuance

amount to £235bn, with roughly £200bn in inflation-linked gilts and £35bn of corporate issuance.

The liquidity on the long-end has improved.

But not enough to match pension schemes’ appetite

This should be great news for pension schemes as they establish de-risking strategies and seek

matching assets. However, the inflation-linked market growth is not enough to match the inflation-

linked part of the £1,200bn UK pension schemes’ liabilities. This mismatch between demand and

supply is not likely to revert soon, pushing the real yield at the long-end lower.

Alternative sources of inflation-linked assets

In order to avoid this shortage of supply, pension schemes should compare index-linked gilts

opportunities to other solutions available in the Liability Driven Investment space. There are often

other ways to hedge inflation risk at a lower cost and still benefit from credit and illiquidity premia.


4

UK Inflation-Linked Markets

From 1981 to now, the UK inflation-linked market has expanded from £1bn to £189bn nominal as of

November 20121.

Of all inflation-linked bonds issuers, the UK has the biggest proportion of its marketable debt being

inflation-linked (only Sweden seems to compete, but with a market ten times smaller). About 22% of

the total gilt market is inflation-linked. In comparison, the Treasury Inflation-Protected Securities

(TIPS) market amounts to $736bn, but only represents 7.5% of their marketable debt (including bills,

notes and bonds)2.

Figure 1: Size of the gilt market

Source: UK Debt Management Office

Corporate inflation-linked bonds

In addition to inflation-linked gilts, about 70 UK companies have inflation-linked debt for a total issue

size of £35bn. This amount has almost tripled since 2005. This is dominated by the utilities sector,

where revenues are closely linked with inflationary developments.

The market is still very concentrated with the ten largest issuers representing about 65% of the total

UK corporate inflation-linked bond market:

1 Data are available on UK Debt management Office website http://www.dmo.gov.uk. The nominal figure for the inflation-

linked gilts is non- inflation adjusted, on an adjusted basis inflation-linked gilts represents £265bn. 2 Data are available on http://www.TreasuryDirect.gov. Non- inflation adjusted; on an adjusted basis inflation TIPS outstanding

amount represents $819bn.

0

100

200

300

400

500

600

700

800

900

1,000

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

£ b

illio

n

Conventional (nominal) Index-linked (nominal)


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Table 1: First ten UK companies by inflation-linked bonds’ issuance

Sector Average time to

maturity

Size

£ bn

Percentage of

corporate IL issue

Network Rail Infrastructure 32 12 33%

National Grid Gas Plc 26 2 6%

Anglian Water Service 32 1 4%

National Grid 21 1 4%

United Utility Water 35 1 4%

Thames Water Utility 37 1 4%

Severn Trent Water 40 1 2%

Channel Link 30 1 2%

Yorkshire Water 41 1 2%

Tesco Plc 13 1 2%

Source: UK Debt Management Office

UK inflation-linked bonds available by maturity

We have sorted the total par amount of both government and corporate IL bonds by 5 year buckets

and shown them in the chart below.

The long-dated inflation-linked liquidity has improved over the last seven years: the total 20yr+

inflation-linked debt represents 60% of total inflation-linked debt, whereas it represented only 34% in

2005.

Figure 2: UK inflation-linked bonds by maturity

0-5yr 5-10yr 10-15yr 15-20yr 20-30yr 30-50yr 50yr +

Corporates 0 2 5 2 12 14 0

Gilts 28 22 24 14 59 64 0

0

10

20

30

40

50

60

70

£ b

illio

n

Years to maturity

Corporates Gilts

Source: Bloomberg, Calculations: Redington


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Inflation-Linked Bonds vs. Inflation-Linked Liabilities

Based on estimates from The Pension Protection Fund (PPF) as of March 2012, UK Defined Benefit

total liabilities amount to £1,231bn; 56% of those are inflation-linked. This is about three times the

total size of the UK’s inflation-linked bond market.

Figure 3: UK inflation-linked bonds and equivalent pensions’ liabilities by maturity

Source: Bloomberg, PPF, Redington

This mismatch in supply and demand, among other factors, has pushed down long-dated UK real yield

levels as the latest results of gilt auctions show:

Table 2: Summary of last six months index-linked gilts’ issuance

Auction

date

Gilt name Amount issued,

£ mn

Yield Times

covered

Dec-12 0⅛% Index-linked Treasury Gilt 2024 1,130 -0.58% 2.37

Nov-12 0¾% Index-linked Treasury Gilt 2047 900 0.29% 1.75

Oct-12 0⅛% Index-linked Treasury Gilt 2024 1,649 -0.44% 2.56

Sep-12 0¾% Index-linked Treasury Gilt 2034 1,346 0.13% 1.55

Aug-12 0⅛% Index-linked Treasury Gilt 2029 4,297 -0.03% -

Jul-12 0½% Index-linked Treasury Gilt 2050 932 0.11% 2.08

Jun-12 0⅛% Index-linked Treasury Gilt 2029 1,366 -0.11% 1.83

Source: Bloomberg, PPF, Redington

There is no apparent reason to think this trend will revert, given that 80% of pension funds have a

hedge ratio of less than 50%, and many of them have plans to move further from equities into

matching assets.

0

20

40

60

80

100

120

140

160

180

£ b

illio

n

Years to maturity

UK Pensions' inflation-linked liabilities Corporates Gilts


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Alternative Sources of Inflation-Linked Assets

In this context, accessing real yields through index-linked gilts may not always be the optimal solution.

The decision to enter the index-linked gilt market should come after an evaluation of current gilt yield

levels and opportunities to lock in substantial improvements along the curve.

The use of derivatives, such as swaps, can lower the cost and tailor the exposure to the pension

scheme’s need. However, given new bank capital rules, these kinds of long dated trades are

becoming more expensive for them to intermediate and, therefore, the price of derivatives is

increasing.

Another way to hedge inflation risk is using nominal corporate bonds overlaid by inflation swaps

through banks. For the same regulatory reasons, this is already becoming more costly and less

efficient and looks set to continue. In this new environment, both sides, issuers (such as utility

companies) and pension schemes, will find it more expensive to hedge via a bank balance sheet.

Therefore, pension schemes should be looking to source this supply directly.

As the cost of entering into inflation swaps with banks rises, utility companies may issue more

inflation-linked bonds and search for replacement counterparties for their existing and new inflation-

linked swaps. Pension schemes should be prepared to spot good opportunities in this space.

Pension schemes now have available to them a wider choice of alternative solutions to match

liabilities’ inflation risk, and they do not need to give up the risk premium. Investing in infrastructure,

social housing or secured leases can be as efficient as inflation-linked bonds are to hedge against a

rise in inflation, but they deliver an additional premium for credit and illiquidity.


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About the Authors

We would welcome the opportunity to discuss further. Please do get in touch to find out more.

Robert Gardner

Co-Founder & Co-CEO

• Robert co-founded

Redington in 2006 to help

clients implement a clear 7

step process to full funding

• Started his career at

Deutsche Bank before

joining Merrill Lynch in their

Insurance and Pensions

Solutions Group

• Named in ai CIO’s Top 25

Investment Consultants in

the World 2012

• Also in Financial News’ 100

Rising Stars (Investment

Consulting) in 2009

• Avid supporter of Commando

Spirit and board member of

The Catalyst Club

Contact:

+44 (0) 20 7250 3416

[email protected]

Marina Jelesova

Analyst, ALM & Investment Strategy

• Marina joined Redington

in September 2012

• Previously worked at BNP

Paribas with a focus on

hedge fund analysis

• Holds an MSc degree in

Financial Markets from

EDHEC Business School

Contact:

+44 (0) 20 3326 7158

[email protected]


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If you would like more details on the

topics discussed, please contact your

Redington representative, the authors

or email [email protected]

www.redington.co.uk

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Red views inflation-linked-bonds-issuance-and-pensions-liabilities-january-2013

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