Inflation linked debt had a dreadful year in 2022 due to the LDI crisis. But with inflation likely to remain high, could Linkers celebrate a comeback?
With the triennial valuations completed, many Local Government Pension Scheme (LGPS) investors are now reviewing changes to their strategic asset allocation. For many schemes, improved funding levels combined with an increasingly uncertain outlook for the global economy have sparked a debate over how LGPS portfolios, which have traditionally been equity-heavy, could be further diversified.
Fixed income is an asset that has increasingly crept up on investors’ agendas. But while headline consumer price index (CPI) figures have finally fallen below 10% this month, core inflation in the UK has risen to 6.8%, suggesting that price rises might be here to stay. This is bad news for conventional debt, but should – in theory – be good news for inflation linked debt.
Yields at mini budget levels
Indeed, demand for fixed income among the usually institutional buyers such as corporate defined benefit (DB) schemes has been muted among hotter than anticipated inflation data. By the end of May, yields on 30 year gilt yields shot up to 4.6%, levels not seen since the now infamous mini budget in autumn last year.
Back then, it was easy to pin the blame on former prime minister Liz Truss’ leadership. But this time, the drag on bond markets is caused by a toxic combination of increased bond issuance, with the Debt Management Office on track to issue almost £240bn in new debt this year, and lack of demand from institutions, due to persistently high inflation. Add the fact that the Bank of England is now embarking on selling bonds to the market as part of its quantitative tightening programme, and it becomes easy to see why there is trouble brewing in UK gilt markets.
The fall in bond prices has also manifested itself in the Linkers market, where the CPI linkage could provide a helpful cushion to combat the impact of price rises. Indeed, yields for 30 year index linked gilts stand at more than 1% and could climb even higher. So could now be an opportune time to buy Linkers?
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Inflation headache
Sourcing assets that mitigate the effects of price rises is a challenge for LGPS investors in particular, as the latest Room 151 Roundtable on Bonds revealed. With pension benefits in the public sector being linked to inflation, a 10% uplift on payouts has now kicked in; funds are being hit with additional pressures on their cash reserves.
Added to that are improved funding levels, which feed into a growing interest in bonds argues James Sparshott, head of Local Authorities at LGIM: “There is an emerging theme happening on fixed interest. If we look at the typical LGPS allocation now or certainly over the last few years, it was dominated by equities but with improving funding levels, you will see further diversification. Given where fixed income is now, compared to where it was a year or 18 months ago, this is now an asset class that has come into focus and will continue to be in focus for local government. We have seen some searches out there for fixed income, interestingly clients looking for fixed income that also delivers some form of ESG integration and I think we are going to see more of that.
Buying inflation linked debt could be one way of mitigating that challenge, argues Leandros Kalisperas, co-CIO of the West Yorkshire Pension Fund and one of the roundtable attendees. While the fund, which is part of the Northern Pool, has traditionally been equity heavy, it is now looking towards bonds as a source of diversification: “One of the questions I am now asking myself is whether inflation linkage, specifically, contractual and clear is something we need to take more of when rebalancing the asset allocation,” says Kalisperas.
But inflation linked debt is of course not without risk, as many corporate DB schemes learnt last year. Much will depend on the outlook for interest rates, argues Tim Mpofu, head of pensions and treasury at Haringey Council, who also attended the event. Haringey has traditionally managed its inflation risks through inflation linked debt, but this turned out costly last year when the prices of Linkers fell due to a drop in inflation expectations.
The fund is now looking to review its fixed income allocation and potentially cutting back its exposure to Linkers due to the uncertainty of the inflation outlook.
Indeed, Linkers are much more vulnerable to changes in inflation expectations than conventional gilts, with a 1% decrease in inflation expectations leading to a potential price fall of almost 14%, nearly three times as much as that of conventional gilts.
Liabilities match
Some still think that Linkers will have a role to play, precisely because prices are now so low. Among those is Mike Jensen, director for investments at Lancashire County Council and former CIO at Local Pensions Partnership Investments. He argues that Linkers offer opportunities, if they are being bought on a buy and hold basis and without the use of leverage.
“For a fixed income investment pool, they are probably not the right instrument, but for a liability management pool, they most definitely are,” he says. “Most LGPS schemes are now in surplus, with Linkers now at 1.5% real yields, they ought to be allocating away from risk assets for the historic liabilities and going towards de-risking assets.
“The issue here is that ‘Trussonomics’ has put a bomb under liability-driven investment (LDI) strategies, especially those with gearing. That has got into the psyche of pension fund managers and they know that gilt markets are now at risk should government screw up again. Even though inflation protection is now incredibly cheap, it would be quite brave for a fund to bite the bullet and make that move but if they are serious about locking down their historic liabilities, they really ought to be.”
Even though inflation protection is now incredibly cheap, it would be quite brave for a fund to bite the bullet and make that move but if they are serious about locking down their historic liabilities, they really ought to be” Mike Jensen, director LCC.
This view is backed by William Bourne, an independent advisor to the LGPS at Linchpin Advisory, who has in the past been sceptical of the case for Linkers. “Linkers make an excellent hedge against inflation risk. The issue is how much you pay for them. For much of the last ten years they have had negative real yields so you were paying up to 3% annually for your inflation insurance,” he notes.
“Now you get a positive return they are much more attractive to LGPS funds and I am encouraging clients to build up their allocation. But I suspect yields will go higher still, so better to build it up over time.”
Timing is everything
The issue of timing is indeed a concern for many LGPS investors, who may not have the operational setup to respond to short-term market challenges. As a result, many LGPS investors were unable to capitalise on the opportunities that last year’s market meltdown brought. In theory, this could have been an opportunity to buy inflation linked debt at bargain prices. But with most investment committee meetings taking place on a quarterly basis, LGPS funds were unable to respond to an event that unfolded over the course of days.
Sparshott also sees opportunities in Linkers but argues that timing is crucial:”The balancing act here, as with any investment, is the point of entry: Has this still some way to go? Certainly you see her that gilt yields have been elevated and investors are really thinking at what point to go in and whether to phase the entry.
He believes that there are options to navigating the governance challenges and creating more flexibility: “What we see some clients do is they sit down with their advisor and the decision is made on a number of possible investment decisions and then it could be sub delegated to an investment committee so that they can move quicker and target opportunities. Another way of doing this is delegating this away to a fund manager who can move at a quicker pace to shift the asset allocation. Yes, it is important to assess market conditions, but the bottom line is still that pension funds are long-term investors and don’t day trade.
Another concern is market depth, which in the case of Linkers, is about “as deep as a puddle”, Jensen jokes. In that respect, the LDI crisis was perhaps the buying opportunity of a lifetime. “The question would have always been how many could you have bought? During the LDI crisis, you could have bought quite a lot. If the LGPS could have acted as buyers of last resort, they could have made a fortune. Now, how many could you buy before you start to move the market? Not very much,” he warns.
In practice, that means that any entry into the Linkers market would have to be gradual and placed in cautious instalments, Jensen argues.
Jensen also advocates a gradual approach but adds that this could also be easily implemented through employing a bank: “If you think you are going to time it, you are probably not going to succeed, you will have to implement it in several steps and accept that the fact that you are buying will drive the prices up,” he acknowledges.
Going forward, there are also external factors that could drive up the price of Linkers. The most important of these is the fact that the UK government is unlikely to increase Linker issuance. From the point of view of the Treasury, this has been an expensive experience.
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