Index-linked gilts have been hit by news that the Office for National Statistics has started a consultation on changes to the way in which the retail price index (RPI) is measured. The changes, which could result in the RPI moving at the same rate as the consumer price index (CPI), which is traditionally lower and moves more slowly, would have a direct effect on index-linked bonds. However, Lyon thinks the effect would be muted.
The manager, who runs the five crown-rated Trojan fund, said: "We believe the most likely outcome will be a fudge — lowering the index measurement by 0.4 per cent per annum."
"Much is already discounted and once this distraction is behind us, normal service will be resumed for ‘linkers’."
Index-linked gilts have had a poor 2012 in terms of performance, especially in comparison with previous years.
Lyon continued: "Index-linked gilts have been lacklustre of late. Having enjoyed a stellar 2011, they have marked time this year."
According to FE Analytics, during 2011 the FTSE British Government Index-Linked All Stocks returned 19.94 per cent.
However, over the last 12 months it has been a different story, with the index making only 2.64 per cent.
Performance of index over 1-yr
Source: FE Analytics
Despite this, Lyon thinks the ONS cannot afford to make too drastic a change. He believes that lowering the RPI would be viewed as the Government being unable to repay its investors.
"Investors hate uncertainty and the review by the ONS into how the RPI should be measured has provided much anxiety," he said.
"While it is in the interests of the Treasury to use a formula that understates the cost of living, they must tread carefully."
Lyon added: "A radical move to reduce the RPI may be perceived as a partial default."
Index-linked gilts make up 16 per cent of the £2.3bn Trojan fund’s total assets.
Mark Dampier, head of research at Hargreaves Lansdown, agrees with Lyon and believes that the credibility of the Government rests on the RPI not being lowered too drastically.
"I don’t claim to be an expert on the possibility of a default, but it doesn’t look particularly good at the moment. If the RPI was lowered to that of the CPI, what is the point of having it in the first place?"
"I would agree with Sebastian [Lyon] because it does look an awful lot like manipulation; so I think the Government has to tread very carefully in that respect."
"If the index is lowered too much, the Government would certainly lose credibility with the international community and investors. It could also have a very adverse effect on the general bond market."
Dampier thinks that investors who want to hold Government bonds should look to shorter-duration securities instead of the index-linked gilts, despite the uncertainty over the RPI.
"Investors need to remember that index-linked gilts are more longer duration than conventional gilts, and are more likely to take a hit if the general bond market struggles," he said.
Boutique fund manager Ruffer shares Troy's sanguine view.
A spokesman for the group said: "The temperature around the discussions led by the Consumer Prices Advisory Committee on 'improvements to the calculation of UK RPI' is rising and will likely reach boiling point in January."
"Early next year, following a number of neatly choreographed steps, the chancellor may be forced to choose between lower interest on RPI-linked debt and the massed ranks of UK savers waving National Savings Index-Linked Certificates, crying selective default."
"The extremely weak performance of the long-dated index-linked over the last six months might suggest that the market has largely discounted the worst. We are therefore sanguine on the short-term performance of the asset class, while our conviction on its longer-term merits remains completely undimmed."
Sebastian Lyon's quotes were wrongly attributed to Francis Brooke at the time the article was originally published. FE Trustnet would like to apologise for any confusion this may have caused.