Don’t buy this index-linked debt

June 3, 2009

REUTERS– Neil Collins is a Reuters columnist. The views expressed are his own –

This rather odd chart from Monument Securities says something curious — http://graphics.thomsonreuters.com/commentary/INDEX-LINKED-CURVES.pdf. — It shows that British investors (or at least the buyers of UK Government index-linked gilts) are much keener to buy protection against inflation than the holders of French and U.S. government bonds.

A yield curve plots the return on bonds against their longevity, and this one shows that in all three countries, the short-dated index-linkers promise to be pretty dull investments.

Since inflation is currently negative (on some measures) and it takes a while to get going, this is hardly surprising.

The obvious divergence is in the area of the chart covering stocks that have between 12 and 20 years to run. There is a reasonable supply around these dates, so liquidity is not an issue. All the U.S. dollar index-linked TIPS and all the French euro index-linkers yield between 2.1 and 2.2 percent, in each case protected against the relevant national inflation rate.

The British stocks are way out of line, returning around 1.2 percent on top of the UK Retail Prices Index, a full percentage less than is available elsewhere.

In an international marketplace, this is strange indeed. The calculations of inflation vary somewhat between the three countries, but they should even out over time.

In addition, the extra inflation to which the UK economy has been historically prone ought to be balanced by currency depreciation, if not in the short term, at least over the life of these bonds.
Something more than a generalised view of global inflation is at work here. The answer, almost certainly, lies at the door of the British pension fund actuaries. In their obsession with matching assets to liabilities, they insist that the funds put more and more into government bonds, and especially index-linkers.

These bonds do indeed provide the best match available, and allow the actuaries to do their baleful sums, but the prices have been driven to ruinous heights (with the correspondingly pitiful yields) as a result of their demands.

As a result, British companies must pour ever greater sums into their pension funds, and as prices go up, more capital is demanded to produce any given income.

The U.S. and French index-linkers offer much better value than the expensive UK versions, so a pension fund buying those instead could break this vicious circle.

The actuaries will moan about the currency risk, but that looks far less than the risk of bleeding the businesses which are liable for those pensions, a couple of decades hence.

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