UK inflation-linked bonds have rallied in the wake of a government decision this week to reduce the interest payments they offer without providing any form of compensation to holders — a market reaction that has left some investors scratching their heads.
On Wednesday, chancellor Rishi Sunak confirmed that the retail prices index, the controversial measure of inflation relied on by the £400bn “linkers” market, will be scrapped in 2030 and replaced with the consumer prices index including housing costs (CPIH), a gauge favoured by the UK’s statistical authorities.
The switch to CPIH, which typically runs at nearly a percentage point lower than RPI, means that repayments on linkers — which are tied to the underlying inflation index — will be lower, starting in a decade’s time. Even so, bond prices have gained, leading to a rise in break-evens, the expected level of inflation implied by the linker market.
“The market is moving in a counter-intuitive way,” said Ben Lord, manager of an inflation-linked bond fund at M&G Investments. “Break-evens shouldn’t be moving significantly higher, but should be moving lower.”
The announcement came at the end of a government consultation over whether to shift to CPIH in 2025 or 2030. Bonds maturing before 2030 enjoyed the strongest rally as the threat of an earlier switch was removed, but longer-dated linkers also gained. That pushed the 30-year break-even from just below 3 per cent on Wednesday morning to 3.1 per cent on Friday, implying three decades of inflation well above the Bank of England’s 2 per cent target.
Mr Lord said he thought long-dated break-evens should be as much as 0.7 percentage points lower, given weak current levels of inflation. CPIH for October, the most recent reading, was just 0.9 per cent.
Some analysts said the rally was a sign that markets had broadly anticipated Wednesday’s news.
“In theory this should be negative for the long end, but we’ve seen a strong bounce because this outcome had been largely priced in beforehand and there’s relief that the change isn’t happening even earlier than 2030,” said Daniela Russell, head of UK rates strategy at HSBC.
The market moves are a continuation of the long-running tendency of the UK linkers market to price in above-target inflation, a characteristic that marks it out from other major bond markets. That is partly a result of relentless demand from pension funds, who use inflation-linked bonds to hedge their liabilities to pensioners. The uncertainty over the future of RPI had led some funds to slow that activity in recent months, according to Ms Russell.
“Now that this is resolved, some of that demand is coming back,” she said.