Chancellor George Osborne outlined legislation in the Budget that will allow the Government to issue index-linked gilts later this year that track the consumer price index (CPI) instead of the retail price index (RPI).
Although still in a consultation phase, the issuing of CPI-linked gilts is designed to fill a gap in the market after the Government moved to tighten public sector pension liability in accordance with CPI and not RPI. Currently, pension schemes hedge against liability using gilts linked to RPI.
"To understand the legislation we must rewind to about nine months ago when pension minister Steve Webb said benefits would be linked to CPI instead of RPI, because CPI tends to run about 0.75 per cent lower and would save the Government money," explained Graeme Caughey, who manages Scottish Widows Gilt.
"Webb then opened a can of worms by saying pension liability should be linked to CPI."
The legislation is still going through Parliament and depends on whether there is enough demand for CPI-linked gilts. According to Caughey, demand is likely to come from pension providers, who will see CPI-linked bonds as a more appropriate hedge against CPI-linked pension liability.
"This could all be shot down if there is no demand but we happen to know of some very large pension companies who would be interested," he said.
Jonathan Gibbs, who heads up Standard Life UK Inflation Linked Bond, says that further down the line there could be dramatic changes in the UK gilt market.
"To begin with the CPI-linked market would be relatively small and illiquid but it is possible that in the long-term the gilt market might convert from RPI-linked bonds to CPI-linked investments," he said
"This may create a market for trading CPI against RPI."
Caughey agrees: "If there is an offer in Government bonds of a gilt that offers RPI + 1 per cent and one that offers CPI + 2 per cent, the CPI-linked bond may be more attractive from an investment point of view."
"Over the very long-term, perhaps 15 or 20 years, this could cause an evolution of the gilt market. All eyes will be on the Debt Management Office as to whether this bill goes through."
David Scammell, who heads up Schroder Gilt & Fixed Interest, says that the gilt market continues to face challenges in the shape of high inflation, high borrowing and a complacent Bank of England.
"Concerns about the growth outlook have intensified, thereby raising the cumulative borrowing numbers by around £35bn. However, the Government looks to have overfunded in 2010-11 due to a slightly lower-than-projected cash deficit, and is still on track to achieve its new fiscal rules."
Performance of funds vs sector over 5-yrs
Source: Financial Express Analytics
According to Financial Express data, Standard Life UK Inflation Linked Bond returned 33.3 per cent over the last five years, compared with 20.9 per cent from the UK gilt sector average.
Scottish Widows Gilt and Schroder Gilt & Fixed Interest have underperformed the sector average over the period, returning 19.4 per cent and 17.2 per cent respectively.
"The market remains well supported by investors, particularly those from overseas, who seem to applaud the Government’s fiscal consolidation plans. The 2011 Budget re-affirmed the austerity plans laid out last year and thus will do little to change the overall sentiment," finished Scammell.