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

  1. 1. Inflation-Linked Bonds Issuance and Pensions Liabilities January 2013 For Institutional Investors
  2. 2. Contents Executive Summary 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 January 2013 3 9 For Institutional Investors 2
  3. 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 inflationlinked 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. January 2013 For Institutional Investors 3
  4. 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 1,000 900 800 700 £ billion 600 500 400 300 200 100 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Conventional (nominal) Index-linked (nominal) 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: Data are available on UK Debt management Office website The nominal figure for the inflationlinked gilts is non- inflation adjusted, on an adjusted basis inflation-linked gilts represents £265bn. 2 Data are available on Non- inflation adjusted; on an adjusted basis inflation TIPS outstanding amount represents $819bn. 1 January 2013 For Institutional Investors 4
  5. 5. 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 70 60 £ billion 50 40 30 20 10 0 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 Years to maturity Corporates Gilts Source: Bloomberg, Calculations: Redington January 2013 For Institutional Investors 5
  6. 6. 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 180 160 140 £ billion 120 100 80 60 40 20 0 Years to maturity UK Pensions' inflation-linked liabilities Corporates Gilts 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. January 2013 For Institutional Investors 6
  7. 7. 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 inflationlinked 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. January 2013 For Institutional Investors 7
  8. 8. 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 • Contact: Also in Financial News’ 100 Rising Stars (Investment Consulting) in 2009 • Robert co-founded Redington in 2006 to help clients implement a clear 7 step process to full funding Named in ai CIO’s Top 25 Investment Consultants in the World 2012 • • Avid supporter of Commando Spirit and board member of The Catalyst Club • Started his career at Deutsche Bank before joining Merrill Lynch in their Insurance and Pensions Solutions Group +44 (0) 20 7250 3416 Marina Jelesova Analyst, ALM & Investment Strategy • • Marina joined Redington in September 2012 • Holds an MSc degree in Financial Markets from EDHEC Business School Previously worked at BNP Paribas with a focus on hedge fund analysis January 2013 Contact: +44 (0) 20 3326 7158 For Institutional Investors 8
  9. 9. If you would like more details on the topics discussed, please contact your Redington representative, the authors or email Stay up to date with our latest thinking Download the RedApp More Redington Publications Disclaimer The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information i s for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this document is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence. This presentation may not be copied, modified or provided by you, the Recipient, to any other party without Redington Limited’s prior written permission. It may also not be disclosed by the Recipient to any other party without Redington Limited’s prior written permission except as may be required by law. Redington Limited is an investment consultant company regulated by the Financial Services Authority. The company does not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional, tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate. Registered Office: 13-15 Mallow Street, London EC1Y 8RD. Redington Limited (reg no 6660006) is registered in England and Wales. ©Redington Limited 2013. All rights reserved. January 2013 For Institutional Investors 9