LONDON, 15 September 2003 — UK index-linked gilts, once seen as a dull but safe asset, are coming strongly into vogue as a slew of data pointing to an economic upturn prompts some investors to start protecting against inflation.
A recent fund survey by Barclays Capital showed 66 percent of respondents said they planned to increase index-linked asset holdings in their portfolios in 2004.
But inflation risk is not the only factor that draws investors to so-called “linkers”. A looming change in the inflation target in the UK and an increase in appetite for assets that guarantee real yields among funds in Europe and the US are also a boon for the asset.
Hence some analysts reckon inflation-linked gilts will perform reasonably well in the coming months despite them looking expensive now, with their breakeven rate rising by 20 basis points since late June to 265, and despite the recent change in UK regulations which reduces pressure for certain pension funds to buy index-linked gilts.
“We like linkers and intend to increase our holding of index-linked gilts to 15 percent from around 10 percent now in the next three months,” said Alan Wilde, fund manager at Abbey Asset Management.
“They do offer something of an each way bet. The other technical aspect is that the sector has received wider interest not only in the UK but also in other parts of the world especially in Europe, and that should have a spillover effect on I-L gilts” he said.
Breakeven rate is a yield spread between conventional bonds and linkers. It is widely used as an indication of inflation expectations. Inflation-linked bonds protect against the value-eroding effects of inflation by linking gains in the retail price index to the bond’s principal and yields.
The Bank of England cut interest rates by 25 basis points in July and many believe that is the last reduction for this economic cycle. Nearly every indicator since that cut has pointed to economic recovery. House prices are rising, consumer spending is robust, the service sector is expanding, and even the downtrodden manufacturing sector seems to be on the mend.
Interest rate futures markets have priced in a possible rate hike by the end of this year, although many economists suspect interest rates can afford to remain low for a while. “One of the major issues at the moment is whether deflation is off the agenda, at least in terms of market mind. If you look at the breakeven level, it has widened and, on the face value of it, highlights some concerns about inflation,” said Andre De Silva, strategist at HSBC. But even if inflation might not pick up any time soon as growth outlook remained at best tentative, some investors might want to hold on to safe bets.
Index-linked assets can overcome two types of uncertainty - both real growth and inflation. They guarantee against the inflation risk that faces conventional bonds when the economy turns around.
At the same time, they also provide a guaranteed real return, if held to maturity, at a time of growth uncertainty - a benefit that equity investors barely have.
Those were among key factors that drove global demand for inflation-linked assets recently, especially in Europe where the market for this sector was still relatively small. According to Barclays Capital, the inflation-linked bond market in the euro-area has doubled in size in the past 18 months to over 50 billion euros.
“As populations age and private pensions grow in Europe, there is a real need for more real yield certainty because most of their liabilities are denominated in real yields,” said Alan James, analyst at Barclays Capital.