[uk_rpi] [common_UK_approach] [gilt_yield_comparisons]

To the best of our joint knowledge of UK practice, this is defined as the “conventional” yield minus the “index-linked” yield, with corresponding durations. This approach is, apparently, used for swaps. So, in order to avoid circularity, we can't take swaps as an alternative approach.

Although FRS17 refers to duration for discount rate (32), it doesn't refer to duration for inflation (26). Nor does PPF for 179 assessments, where one size fits all. Given that yield curves tend to slope upwards, that does beg questions.

While similar outstanding terms may seem logical, maturity may be more of a problem than has generally been observed. After all, the ILG “duration” must be longer than for conventional gilts because the return is more heavily weighted towards capital. Indeed, at present, the weighted mean coupon is equivalent to 0.55%, with a number of ILGs having been issued with a coupon as low as 0.125%.

In fact, we should really be discounting each individual year’s cashflows (which some firms do). Focusing upon cashflows is definitely something to be encouraged.

Taking this approach as it is, what happens? We can compare initial estimates with actual outcomes and look at the differences over time. That is what we have done first, using the “over 15” gilt indices for the estimates against RPI over 15 years. Although, secondly, the errors have recently been somewhat lower than in the past, we would not want to rely upon that continuing into the future. It will be seen that the differences have sometimes been enormous (for example, 4.1% for 1990 to 2005), which is why we originally started seeking alternatives.