[uk_rpi] [ILG_market_setting] [who_wanted_ILGs]

Thinking about index-linked gilts (“ILGs”), we started wondering why they have been so strongly recommended by actuaries and TPR. A longer version with charts has kindly been hosted by Henry Tapper but here are the main points.

1.  ILGs are inflexible. If trustees are looking for inflation-proofed income in order to support pensions in payment, then they must buy an extremely large capital sum. Alternatively, if they really want inflation-proofed capital, for reasons we don’t understand, then they must also buy driblets of income. Jon wrote about that in 1987, proposing a solution.

2.  Few private sector pension rights are even fully linked to inflation, with different limits applied to different pension tranches. This suggests that ILGs provide inflation protection which may be unneeded.

3.  ILG investment returns have not been so good as to offset these disadvantages. Over periods of 15 years, the average annual return was 8.18% for long index-linked gilts against 7.91% on long conventional gilts, a slightly better performance by 0.27%. During 2022, both types of long gilts returned very high negative returns, being 46.92% (index-linked) and 40.05% (conventionals).

4.  The modified duration of a typical scheme is around 20 years, which is around one-half of the modified duration for a long ILG. The passage of time, with rates unchanged, will leave the relative durations changing at different rates. In turn, that will make it much harder to hedge discount rate sensitivities.

5.  Concentrated ownership of a security results in extreme price behaviour in terms of both highs and lows; an exaggerated form of the risk on / risk off behaviour. This was particularly evident in the year ended October 2022, when the ultra-long linkers fell by more than 85% in price, over 10% more than conventionals.

6.  When LDI struck in September 2022, gilts came under pressure from the margin calls of leveraged positions. The Bank of England intervention was initially limited to purchases of conventional gilts, which is consistent with their actions in quantitative easing which was limited to conventional securities. The decision to expand the facility to include ILGs can only be interpreted as being driven by a desire to preserve a viable ILG market and that channel of government financing.

We can discern no substantial arguments for the systemic importance of ILGs. Why they have been so strongly recommended by actuaries and TPR?