Are post-2030 ILGs discounted for CPIH?

aroominyork

If I compare 2029 and 2038 nominal and index-linked gilts, looking at the YTM of the former and the real yield of the latter, I see:

Nominal:

TS29 4.86%

TR38 5.54%

ILG:

T29 0.84%

T38 2.14%

If I understand correctly, the difference between the two shorter and the two longer dated instruments should be about the same, but we see the shorter one is 4.02% (4.86% - 0.84%) and the longer one is 3.40% (5.54% - 2.14%). Does the difference of 0.62% represent the market discounting post-2030 ILGs to reflect RPI being aligned with CPIH?

masonic

The difference represents implied forward inflation, which is never flat over time. It is well known that RPI is to be aligned with CPIH in Feb 2030. What isn't known is what future inflation will be, and what premium RPI would have been over CPIH if no change were made to its calculation (there are good arguments for it not being as high as the historic 1% difference).

Near term inflation is expected to be relatively higher than medium term inflation, with an implied drop even before 2030. See https://www.bankofengland.co.uk/statistics/yield-curves

Note the increasing premium at the long end of the implied inflation forward curve. One could make the specious argument that this is the gilt market finally getting around to pricing in the change from RPI to CPIH in the last week. Or maybe there are other factors to consider…

GeoffTF

https://forums.moneysavingexpert.com/discussion/6684628/are-post-2030-ilgs-discounted-for-cpih

Here are the OBR's projections, for what they are worth:

https://obr.uk/box/the-long-run-difference-between-rpi-and-cpi-inflation/

RPI has typically been about 1% pa more than CPI. The OBR estimates that the difference between CPI and CPI will fade away by 2030. That would suggest that the old calculation for RPI will continue to be typically be 1% more than both CPI and CPIH.

Your 2029 numbers suggest that the market expects 4.86% annual RPI inflation over the next 2.5 years, i.e about 3.86% CPI inflation. That looks plausible to me. Your 2038 numbers suggest that the market expects CPIH inflation to be 3.40% over the next 12 years. If we believe to OBR, that suggests that CPI inflation will also be about 3.40%.

0.62% is less than the typical difference between the old calculation of RPI and CPI of 1%. The market appears to expect that CPIH will be a little higher than CPI or that inflation will be a little higher after 2030.

leosayer

What types of IL Gilts buyers are going to be sensitive enough to this change to adjust their trading behaviour?

Those who buy to meet RPI-linked liabilities of their DB Pensions and Annuities might not be.

aroominyork

This stuff makes my brain hurt! Let me please ask another way. I own T29 and am thinking whether to buy post-2030 ILGs. Is there a way to calculate whether the market has adjusted the price of ILGs to compensate investors for the alignment of RPI with CPIH, ie to 'give back' some of the c.0.9% reduced inflation uplift?

GeoffTF

https://forums.moneysavingexpert.com/discussion/comment/82149600#Comment_82149600

The RPI calculation changes in 2030, so that RPI linked DB pensions and annuities will subsequently be uprated by CPIH, rather than the old RPI calculation, as will IL gilts. There will be people in the market who will have their own inflationary expectations and choose between conventional and IL gilts accordingly.

masonic

https://forums.moneysavingexpert.com/discussion/comment/82149603#Comment_82149603

No, there is no way to calculate the contribution of one factor affecting a security's price and separate it out from the other factors affecting price. It is only possible to guess that things are or are not priced in.

The change was made official in November 2020. There was no clear market reaction at that time, and the thinking was that market participants saw this coming well in advance (given there was extensive consultation ahead of the announcement spanning many years). Any rational buyer of ILG will understand that post-2030 ILG they buy will be based on CPIH from 2030 and that it is an uncompensated changed.

There are two questionable assumptions in your post. Firstly that the change warrants a market reaction, and second that it will result in a c.0.9% reduction in inflation uplift vs nothing being done.

Both assumptions are challenged by the fact that RPI itself is changing. Liabilities such as RPI-linked annuities will still be matched to ILG - there is no extra that needs to be found for buyers to meet their expected liabilities. Components of the inflation basket have also been moving off RPI index linking, or will do so when RPI itself changes (e.g. rail fares, vehicle excise duty, water bills, mobile and broadband contracts). It will probably also have an effect on salary negotiations and therefore second order inflation.

leosayer

https://forums.moneysavingexpert.com/discussion/comment/82149607#Comment_82149607

I know all that.

The point I was making was that the change could be neutral to certain institutions that use RPI-linked Gilts to meet their RPI-linked liabilities.

GeoffTF

https://forums.moneysavingexpert.com/discussion/comment/82149686#Comment_82149686

The BT Pension Scheme, Ford Pension Schemes and Marks & Spencer Pension Scheme unsuccessfully took action in the High Court against the change:

https://www.dalriadatrustees.co.uk/high-court-throws-out-rpi-cpih-judicial-review-case/

"When CPIH replaces RPI, will some trustees feel moved to ask for discretionary increases or for changes to be made to scheme benefits to compensate pensioners?"

The changes have the potential to cause problems for pension schemes, and certainly are not good for their members.

masonic

https://forums.moneysavingexpert.com/discussion/comment/82149752#Comment_82149752

Certain schemes took the opportunity to swap from RPI linked increases to CPI linked increases in the 2010s, around the same time the government changed the statutory minimum for pension increases. The schemes would then be benefiting from the difference between CPI and RPI - which they now stand to substantially lose.

Undoubtedly there is also an element of trustees performing their duty to members and standing up for those whose inflation linking remained aligned to RPI too.

The BT scheme illustrates this quite well, because they have a Section C cohort whose uplift is based on RPI, so the effect is neutral on the scheme, but pensioners lose, and a Section A/B cohort whose uplift is based on CPI, so the pensioners are unaffected, but the scheme loses out on the RPI premium.

But ultimately, the real loser was the taxpayer who has historically had to fund index linking running hotter than it needed to.

Despite all of this, I would contend that the pension firms will not "demand" a further premium on ILG, because they have nowhere else to take their business. It is not as though they could take their chances with an equity portfolio as an inflation hedge. There is a separate conversation about the wind-down of DB schemes causing a reduction of demand in general.

GeoffTF

Thanks for that clear account masonic.

But ultimately, the real loser was the taxpayer who has historically had to fund index linking running hotter than it needed to.

When the government was paying out it used CPI, but when it was collecting money it used RPI, e.g. for student loans. I expect that the tax payer will have a net gain from the change nonetheless. If we needed it, this saga is a reminder of how vulnerable financial plans are government rule changes.