Supply outlook
Over the three months since our last report, markets have been increasing the weight being placed on “data-dependency” in the discussion around the normalisation of monetary policy. This has introduced a greater deal of volatility, particularly in the very front end, as the market is still trying to grapple with the timing and quantum of interest rate cuts over 2024. The broader outlook beyond 2024 over the neutral level of interest rates is equally uncertain, with central banks themselves unsure of how deep and fast a rate cutting cycle this could be.
In the UK, April inflation figures cooled less than expected, resulting in a broadly 50-50 split in June vs August rate cut expectations, shifting more heavily to the latter post-data. Following this, with the general election called for 4 July, the blackout period in the run up to the June MPC essentially wrote off any chance of a Base Rate cut at this meeting. Once a new government is confirmed, data dependent decision-making is likely to resume. The persistence of inflation, especially in services, will be difficult for the MPC to look through so it is crucial that the May and June inflation figures do not surprise to the upside if we are to see an August rate cut.
The new gilt remit for fiscal year 2024/25 accompanied the Budget on 6 March but was swiftly revised upward by £12.4bn in April. There are further upside risks to the remit, with c. £10bn in compensation relating to the infected blood inquiry pencilled in. There will be a forecast of the cost at the next “fiscal event”, which will likely be a Budget delivered by the new government in the autumn (perhaps in October after party conferences). Polls suggest that the election result is expected to be a landslide victory for the Labour Party, but the switch of power is not expected to be a market-moving fiscal expansionary event.
The DMO’s issuance calendar for the third quarter of 2024 confirmed plans for 3 inflation-linked gilt syndications, to raise a total of £9bn in cash. Despite continued strong structural demand for the 15-year sector, the DMO listened to investors’ unanimous support for reopening the UKTI 2054 for the inflation-linked gilt syndication (expected in the week commencing 8 July). A second tap is expected to bring it closer to benchmark size, in turn limiting its likelihood as a candidate for future syndications.
The candidates for future inflation-linked gilt syndications after this are less clear. Given the structural decline in demand for ultra-long inflation-linked gilts, in particular from the LDI community, we think the choice of maturity for future inflation-linked gilt syndications will not extend beyond 2054. This was echoed in the DMO’s quarterly investor consultation in May, where LDI investors stressed their preference to retain optionality given the lack of visibility over pipeline of activity, thereby favouring shorter-dated issuance over longer-maturity supply.
A new line in the 15 to 20-year sector is a possibility, as the 2039 bond will soon be at benchmark size. Plugging the obvious gaps in the inflation-linked gilt curve suggests either a 2038 or 2043 maturity would work well – but these are not close to being benchmark tenors (i.e. 10-year, 15-year or 20-year). Judging by the demand for inflation-linked gilts on asset swap from overseas investors in the 15-year sector, future inflation-linked supply could be targeted at this part of the curve. That said, the DMO will also consider the deluge of conventional gilts issuance forecast in the mediums bucket, accounting for the timing of these when identifying potential syndication maturities and timing.
A new 10-year inflation-linked gilt is also a possible syndication candidate, but this is less likely given only £9bn of inflation-linked gilt proceeds allocated to syndications this fiscal year. With syndications also reserved for higher duration and risk events, a new 10-year would more likely be issued via auction. There is a 22-month maturity gap between the 8-month lag inflation-linked gilts maturing in 2035 and 2036, so there is a gap to fill there. A November 2035 maturity would work well as, even though it sits in the same calendar year as the existing 2035 bond, it would fall into the next fiscal year with respect to the redemption profile. Given the recent outperformance and buying of 5 to 10-year inflation-linked gilts, we envisage that there will be interest in sub 10-year supply too, which will more certainly be brought to market via auction.
Finally, we need to mention the 2073 auction on 14 May, which was the first ultra-long inflation -linked supply since the syndication of the same bond at the height of the gilt crisis in September 2022. Given the strength seen at the auction and the fact that it persistently trades rich, it cannot be written off (or any other bond in the 30y+ bucket) entirely from the auction schedule, but we assign a relatively low probability to this, particularly as end-users continue to express a preference for shorter-dated issuance and the DMO is reticent to bring very low cash price bonds via auction and prefers to use tenders should there be specific investor demand for a particular line.
Following the 2054, our base case assumes a new 2038 to be issued via syndication, followed by a re-opening of the same bond via syndication towards the end of the fiscal year.
Figure 1: Inflation-linked issuance 1
Source: Columbia Threadneedle Investments, DMO, as at May 2024
Figure 2: Distribution of inflation exposure issued, by maturity buckets
Source: Columbia Threadneedle Investments, DMO, as at May 2024
Market liquidity
Liquidity was similar, if not marginally improved, for May month-end compared to February month-end.
Figure 3: Liquidity tracker based on a poll of investment bank trading desks’ bid-offer spreads for RPI swaps and inflation-linked gilts (intra-day) at 10-year, 30-year and 50-year assuming trading £50k risk (IE01)
RPI swaps
Inflation-linked gilts
Source: Columbia Threadneedle Investments
Medians are based at 100% of bid-offer spreads in February 2024. The movements in median, from 100%, indicate outright changes in transaction costs, while the changes in the upper and lower quartiles indicate the dispersion of these costs.
Compared to February, transactions costs in the three months to end-May decreased for 30 and 50-year RPI swaps, whereas these were unchanged for 10-year RPI swaps and inflation-linked gilts across all maturities. Both instruments experienced smaller cost dispersion across all maturities. Trading activity is still primarily concentrated at 10 to 30-year maturities, but over the three months to end-May, there has been a meaningful pick-up in inflation-linked gilt buying demand from LDI and real money investors. Aside from real yields being at attractive levels, the strength in equity markets could be a trigger for pension schemes to reallocate out of equities and into fixed income assets as part of their de-risking flightpath. Demand may also arise from insurers choosing to retain gilts as credit spreads remain at tight levels, as well as greater interest from European insurers in sourcing inflation-linked gilts in the format of repackaged notes, which we detail in the next section.
Gilt versus swap inflation
The differential between gilt and swap inflation across the curve, with the exception of 10-year and shorter, has been fairly range bound over the three months to end-May. Peak to trough over this period, 10-year gilt inflation outperformed 10-year swap inflation by c. 6bps. Further out on the curve (30-year), there were momentary spikes around mid-March and mid-April, with swap outperforming gilt inflation, indicative of potential buyout flows picking up in size. We will look at both themes in turn.
At the front end of the curve, the persistently strong performance of 10-year gilt inflation has seen it outperform swap inflation by c. 15bps compared to 1 year ago. This is unsurprising due to the shift shorter in pension scheme liability profiles, which has in turn increased LDI appetite for the 10 to 20-year sector. All three 2033 auctions this year saw strong investor demand, even with the buying of bonds in the sector running up to each auction, which eroded any gilt inflation cheapening.
Further out on the curve, notable flows relate to SPIRE, an established special purpose vehicle platform used to repackage risk and sell yield enhancement notes, effectively combining a debt security and a derivative. As a guide, the yields on repackaged notes linked to the 2047 inflation-linked gilt were shown at c. 3.9 – 4.2% compared to equivalent 25-year French and German government bonds yielding c. 3.3% and c. 2.6%, respectively. The attractive yield pick-up resulted in strong buying of inflation-linked bonds on asset swap by overseas investors. This specifically appeals to euro insurance clients as they seek higher yielding zero Solvency Credit Risk assets that come with a 0% capital charge under Solvency II rules. This buying led to long end gilt inflation outperforming swap inflation, keeping the gilt-swap inflation differential rangebound amidst intermittent buyout hedging (which tends to involve the selling of inflation-linked gilts on asset swap).
That said, on buyout hedging, there are few inflation-linked corporate bonds with a maturity date beyond 30-years, so ultra-long inflation-linked gilts should be relatively immune to the insurer transition to credit. With corporate bonds looking expensive on historical measures, this also supports the case to be long inflation-linked gilts.
Figure 4: Relative z-spread for generic inflation-linked bonds versus comparator SONIA z-spread (3 months to 31 May 2024 highlighted), where higher (lower) level indicates swap inflation outperforming (underperforming) gilt inflation.
Source: Barclays Live
CPI market update
At the Spring Budget on 6 March, the sixth round (AR6) of the UK government’s auction rounds awarding subsidy contracts to support the generation of low carbon electricity, known as Contract for Difference (CfD3), was revealed to be over £1bn. This amount is an enormous increase relative to the fifth round (AR5) budget in 2023. In addition, AR6 will see the maximum strike price raised by 66%. It seems that the government is learning from its mistakes, as AR5’s low budget and strike prices saw no offshore wind projects bid in the auction. This is positive for potential CPI supply to the market, as a higher strike price should attract more bids and in turn the need to hedge the inflation component of firms’ CPI-linked revenue streams by paying away CPI inflation.
There has been a fair amount of coverage on water companies in the news since our last update. Conversations are still ongoing between water companies and Ofwat, the regulator, as the former have indicated that they feel under pressure to prioritise lower bills over improvements to the infrastructure network. With no clear conclusion as yet, there is uncertainty over water companies’ ability to issue debt, albeit this will be specific to each company’s financial position. That said, two water companies issued £100m of CPI-linked notes in the past couple of months, which put inflation hedging back into the market. On 11 July, we will find out whether Ofwat will agree to water companies’ specific requests to increase consumer bills – a decision which may impact companies’ profitability and ability to raise additional capital if they are already highly leveraged.
CPI-linked supply is not limited to water companies but extends to the wider regulated utilities and infrastructure sectors more generally. It is therefore useful to understand what drives these firms’ decisions to hedge. In terms of their back books, they would have had to decide whether to partially or fully hedge their CPIH-linked cashflows; as well as whether to hedge with RPI or CPI-linked assets. Regulators in the utilities sector were a first mover to reference CPIH, but this was done before any of this type of inflation linkage could be hedged. Consequently, regulation is not prescriptive and is open to interpretation, resulting in a divergence in level of hedging and type of hedge. At present, companies range between 20 to 80% hedged.
In the context of RPI reform, firms are faced with the following decisions on forward-looking hedging – they can hedge CPIH-linked cashflows with RPI-linked assets, hence running a large basis risk for 6 years, but aligning 100% post-reform; or hedge CPIH-linked cashflows with CPI-linked assets, resulting in slightly mismatched basis risk throughout. This is far from a straightforward decision as a divergence in hedging strategies across firms will have differing results. To aid with their decision, firms would need to consider whether they can reliably quantify the volatility of the CPIH-CPI basis. Then if the decision is to hedge, whether this is done with physical assets or derivatives. For longer-dated hedges, physical assets are the preferred option of regulators, stemming from a fear of financial engineering by firms, and a lower level of complexity relative to derivatives. If there is more hedging to come from this space, we expect issuance maturities to be around 5 to 10 years.
Figure 5: Indicative spread between RPI and CPI swaps expressed as a strip of forwards4, at 25 November 2020 (RPI reform announcement), 29 February 2024 and 31 May 2024
Source: Columbia Threadneedle Investments, Morgan Stanley
