Viewpoint September 2015 Your Global Investment Authority Navigating Divergent Global ILB Markets: Why Are UK Index-Linked Gilts Persistently Overvalued? Mihir P. Worah CIO Asset Allocation and Real Return The UK index-linked gilt market holds the distinction of being the oldest developed market inflation-linked government bond (ILB) market in the world. The first indexlinked gilt was issued in 1981, well before the U.S. started its inflation-indexed Treasury programme in 1997 and many years before global ILBs became a mainstream asset class. That is interesting trivia for investors to know, but today, given outright valuations as well as relative valuations to other ILB markets, it might be more fitting to award the UK index-linked gilt market the accolade of being the most overvalued. Mike Amey Managing Director Portfolio Manager Berdibek Ahmedov, CFA Senior Vice President Product Manager Of course, in today s New Neutral environment, investors cannot, unfortunately, avoid structurally lower yields on bonds in general. However, current extremely low and negative real yields on UK index-linked gilts, particularly for long-dated bonds, do not appear to have any fundamental justifications. Put simply, it is the seemingly insatiable demand from UK pension schemes that has pushed valuations to extreme levels. These schemes feel they have no choice but to accept ever lower yields as they seek to immunise their inflation-linked liabilities. In this great chase, fundamentals are often ignored and valuations become and quite often stay extreme. While matching assets with liabilities is important, slavishly immunising just one aspect of the liabilities (sensitivity to changes in the discount rate) forces schemes to invest in an asset with low expected returns and almost guarantees a growing funding gap.
Putting the index-linked gilt valuations in perspective As Figure 1 illustrates, the 30-year index-linked gilt real yield has been at or just below zero for a large part of the last three years. In recent months, despite stronger UK growth and a less dovish Bank of England, real yields have dropped to all-time lows. At the current 0.87% real yield, if the 30-year index-linked gilt were to be held to its maturity, it would guarantee investors a whopping 23% loss in real purchasing power in terms of the Retail Price Index (RPI). FIGURE 1: 30-YEAR UK INDEX-LINKED GILT REAL YIELD Percent (%) 2 1.5 1 0.5 0-0.5-1 -1.5-2 -2.5 Jul 05 Jul 07 Jul 09 Source: Bloomberg, data as of 14 August 2015 Another way to assess the valuation of UK gilts is to compare them with other inflation-linked bonds of similar quality. Figure 2 compares 30-year UK real yields adjusted Jul 11 Jul 13 Jul 15 for estimated RPI/consumer price index (CPI) basis with 30- year U.S. Treasury Inflation-Protected Securities (TIPS). The RPI to CPI adjustment is needed because U.S. TIPS are linked to the CPI while UK gilts are linked to the RPI, which has different weights and a different calculation methodology. As the analysis illustrates, over the last 10 years UK index-linked gilts have largely traded at a premium to U.S. TIPS (UK linker yields lower than U.S. TIPS yields), but more recently this premium has exceeded the highs seen in 2008, during the global financial crisis. Apart from a brief period in 2012 when UK linkers underperformed U.S. TIPS because of potentially adverse alterations to the RPI index, UK linkers have become increasingly more overvalued. Real yields on long-dated government bonds are a function of real growth expectations for the economy as well as the creditworthiness of the sovereign. Long-term growth expectations for the U.S. and the UK are roughly similar, while the U.S. is arguably a stronger credit. U.S. and UK CPI inflation have been broadly similar over the long term and this is likely to continue. Hence, one would expect long-term U.S. real yields to be somewhat below those of the UK. Yet, as of 14 August 2015, 30-year U.S. TIPS provided a positive real yield of 1.05%, whereas UK linkers yielded an estimated 0.10% after the RPI/CPI adjustment. Over the life of a 30-year bond, ignoring currency hedging costs, this difference in yields equals a roughly 40% difference in estimated total return between the two bonds in local currency terms, and assuming inflation is similar in the two countries. SEPTEMBER 2015 VIEWPOINT 2
FIGURE 2: 30-YEAR UK ILB REAL YIELD VERSUS 30-YEAR U.S. TIPS REAL YIELD 4 3 2 1 0-1 -2 Jul 05 Jul 06 Jul 07 Jul 08 Jul 09 Percent (%) Jul 10 Jul 11 Jul 12 Jul 13 Jul 14 Jul 15 UK vs US Spread US RY UK RY with RPI/CPI adjustment Hypothetical example for illustrative purposes only. Source: Bloomberg & PIMCO, as of 14 August 2015 Investors should ask two key questions: First, what has driven this chase to the bottom? And second, and more importantly, what does this imply for more flexible investors? The forces driving index-linked gilt yields The main reason for the ever-lower real yields and persistently high inflation breakevens on long-dated indexlinked gilts is the seemingly insatiable demand for inflation-hedging instruments in the UK. According to data from the UK Pension Protection Fund (PPF), as of 31 July 2015 defined benefit pension schemes covered by the PPF in aggregate had 1.5 trillion of liabilities. Most of these liabilities are linked to inflation by regulation, whether it is to the CPI or the RPI. With many schemes now closed, the industry, which traditionally invested in equities to generate high real returns, now faces a shortening investment horizon. In recent years, this has prompted most schemes to start immunising interest rate and inflation risk by buying index-linked gilts and receiving UK inflation via inflation swaps. With only 450 billion of index-linked gilts outstanding and net new annual supply of about 30 billion 35 billion per year, even considering the flows going through the inflation swap markets, supply and demand are significantly mismatched. The regulatory link of pension liabilities to inflation and the requirement to value pension liabilities based on market yield curves have led to a circular behavior between the need for de-risking (more demand for linkers) and market yield levels. As pension funds seek to buy more indexlinked gilts, they cause real yields to decrease. Lower yields, in turn, lead to growing deficits at the aggregate level as liabilities are discounted using these rates. As deficits widen, pension funds are under more pressure to more closely match the interest rate sensitivity of the liabilities, hence being forced to buy more at the lower yields, which imply lower future returns! For instance, according to the PPF, in July 2015, pension fund liabilities increased by 3.4%, reflecting reductions in conventional and index-linked gilt yields. During the same period, assets rose by 1.5%, with overall pension fund deficits widening by 1.9% and that is just one month. SEPTEMBER 2015 VIEWPOINT 3
FIGURE 3: RPI INFLATION RATE IMPLIED BY 30-YEAR MATURITY INDEX LINKED GILTS VS BOE INFLATION TARGET Percent (%) 4.5 4 3.5 3 2.5 2 Jul 05 Jul 06 UK 30yr BEI Jul 07 Jul 08 Jul 09 Jul 10 Jul 11 Jul 12 Jul 13 Jul 14 RPI inflation rate consistent with BoE s 2% CPI inflation target Jul 15 The implications for investors In our view, the choice is simple. Investors who have no regulatory need to own UK index-linked bonds can potentially get better value in other global ILB markets. Valuations are fundamentally much more attractive in the U.S. TIPS market. We believe investors constrained by pension fund regulations to invest only in the UK would be better off spreading their exposures between index-linked gilts and conventional gilts. As Figure 3 shows, the current (RPI) inflation rate implied by index-linked gilts in order to break even with conventional gilts is 3.5%, well above the Bank of England target inflation rate. Unless regulations that offer cheap funding are the government s goal, the best long-term solution in our view would be to relax regulations that cause adverse investor behavior, i.e., forcing pension funds into assets that are guaranteed to return less than the inflation rate if held to maturity. Source:, Bloomberg & PIMCO, as of 14 August 2015 SEPTEMBER 2015 VIEWPOINT 4
Biographies Mr. Worah is CIO Asset Allocation and Real Return and a managing director in the Newport Beach office. He is a member of the Investment Committee and the Executive Committee, and oversees portfolio management for the U.S. He is a generalist portfolio manager who manages a variety of fixed income, commodity and multi-asset portfolios. Prior to joining PIMCO in 2001, he was a postdoctoral research associate at the University of California, Berkeley, and the Stanford Linear Accelerator Center, where he built models to explain the difference between matter and anti-matter. In 2012 he co-authored Intelligent Commodity Indexing, published by McGraw-Hill. He has 14 years of investment experience and holds a Ph.D. in theoretical physics from the University of Chicago. Mr. Amey is a managing director and portfolio manager in the London office. He is responsible for sterling portfolios, the European insurance (ex Germany) and the European LDI (liability-driven investing) portfolio management groups. Prior to joining PIMCO in 2003, he was head of U.K. fixed income at Rothschild Asset Management and after their merger, at Insight Investment. Prior to joining Rothschild in 1994, Mr. Amey spent two years tutoring in the Department of Economics at the University of Durham. He has 21 years of investment experience and holds undergraduate and master's degrees in corporate and international finance from the University of Durham. Mr. Amey is also a member of the U.K. Society of Investment Professionals. Mr. Ahmedov is a senior vice president and product manager in the London office, responsible for global unconstrained bond and real return strategies. Prior to joining PIMCO in 2010, he was with Barclays Capital in London for eight years, most recently as vice president and product manager for global inflation-linked products and fixed income index derivatives. Prior to that, Mr. Ahmedov worked in the index product research group specializing in inflationlinked bond and quantitative strategy indices. He has 13 years of investment experience and holds a bachelor's degree in finance from the University of Lancaster in the U.K. Newport Beach Headquarters 650 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000 Amsterdam Hong Kong London Milan Munich Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. The U.K. Consumer Price Index (CPI) measures the change in prices for retail goods and services, including food and gas. The CPI is the key measure of inflation for the UK and is used by the Bank of England in making interest rate decisions. The report tracks changes in the price of a basket of goods and services that a typical British household might purchase. An increase in the index indicates that it takes more Sterling to purchase this same set of basic consumer items. It is not possible to invest directly in an unmanaged index. New York Rio de Janeiro Singapore Sydney Tokyo Toronto Zurich pimco.com
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