The ABI s Response to the DMO s consultation document

Transcription

1 CPI-linked Gilts The ABI s Response to the DMO s consultation document Introduction 1. This is the response of the Association of British Insurers (ABI) to the Debt Management Office s consultation on whether to issue gilts linked to the Consumer Prices Index (CPI). 2. The ABI represents the UK s insurance, investment and long-term savings industry, the largest in Europe and the third largest in the world. It has over 300 members, accounting for some 90% of premiums in the UK domestic market and manages investments of 1.5 trillion. General Comments 3. The ABI welcomes the publication of this consultation document and the opportunity to respond to it. The legislative changes to index-linking of pension entitlements now coming into effect will have a very significant impact on the nature of demand for matching assets. We believe it is important now for the DMO on behalf of the UK Government to ensure that proposals for issuance of CPI-linked gilts are now taken forward as expeditiously as possible to provide the investment assets that enable those CPI-linked liabilities to be matched. 4. We are pleased that the consultation document addresses the key issues. Together with referenced background papers it demonstrates that there is considerable complexity in forecasting what the impact will be on the nature of pension entitlements and the consequent demand for investment assets to match these liabilities of pension schemes and of insurance companies writing annuities. Although it is difficult to make precise estimates of the consequent impact on investor demand it is clear that in future there will be significant natural demand for both RPI- and CPI-linked assets. 5. Different types of DB schemes will be affected in different ways by the changes, as is clear from the DWP research referred to in the consultation document. Our best guess is that the effective impact on matching requirements would translate into a split of around one-third CPI-linked to two-thirds RPI-linked. However, such estimates must be regarded as provisional at this stage. 6. Some pension schemes do not seek to achieve through their asset allocation a close match with their underlying liabilities but, rather, hold a diversified portfolio of assets with only modest quantities of index-linked securities. For such schemes it is unlikely that the introduction of CPI-linking of liabilities will lead to a change in strategy. Conversely amongst other funds with a desire to match assets and

2 liabilities as closely as possible we expect commensurate shifting from RPI- to CPIlinked assets. As a generalisation schemes seeking a close match will tend to be larger and/or more mature schemes. These schemes have both RPI- and CPIlinked liabilities. Life insurers conducting annuity buy-out business and subject to solvency requirements applicable to insurers have a particular interest in achieving accurate matching of liabilities and therefore the availability of the right matching assets in sufficient quantity. 7. It is also important not to overlook the less direct but nevertheless potentially significant impact on DC schemes and future patterns of annuitisation. At present only a small proportion of annuities written by UK life insurers are index-linked 1. This could change as concerns regarding quantum and unpredictability of future inflation increase generally in the minds of the public and of those at the point of retiring in particular. It is also possible that CPI-linked annuities could potentially be more attractive than RPI-linked annuities have been hitherto. The particular perceived disadvantage of the latter is the relatively low starting income that annuitants will be quoted. To the extent that the CPI calculation methodology leads to lower expected escalation of the index value, the market should expect higher starting yields consistent with equal present values for the stream of future cashflows. This may reduce the perceived disincentive to choose index-linked annuities and lead to a consequent increase in the overall size of that market. Predictions at this stage as to the likely impact on consumer behaviour would, however, be premature. 8. We believe that it will be essential for the UK Government to be an issuer of gilts of both types in the future. The demand for CPI-linked gilts will not replace that for RPI-linked gilts. It will be additional to and in parallel. It will also be important that the UK authorities do not simply view the question as being what split to effect within the index-linked market. The appetite for RPI-linked gilts already outstrips the appetite of Government to issue these. 9. The DMO is right also to identify the risks of fragmentation to the market and this further supports the case for an expansion of overall index-linked issuance as a concomitant of the introduction of CPI-linked gilts. The two types of index-linked gilts will need to be kept separate as regards index eligibility with new benchmark issues of CPI-linked gilts built up and related indices created. 1 Of annuity contracts written in recent years less than 5% were either index-linked by reference to RPI or were of Limited Price Indexation (LPI). 2

3 Questions for Consultation ANNEX 1. What is the potential source, scale and depth of demand for CPI-linked gilts in an absolute context and also relative to RPI-linked gilts? How might such demand translate into cost-effective issuance for the Government? What would be the size of any premium that potential investors would be willing to pay for CPI-linked gilts (e.g. as a spread to RPI-linked gilts)? We envisage that pension schemes and insurance companies will be the main ultimate source of demand for CPI-linked securities as has been the case for RPIlinked. Regulatory pressures of various types will reinforce the interest of pension schemes and annuity providers to hold assets providing an appropriate match for their retirement benefit liabilities. In theory the impact on Government funding costs should be neutral but in practice investors are likely to pay over the odds for the inflation protection that they the seeking. Hence, issuing more index-linked instruments ought to reduce Government funding costs in the long run. It is likely that CPI- and RPI-linked gilts would command similar convenience premia but the ready availability of both types could reasonably be expected to increase the overall attractiveness of the indexlinked gilts to investors and the ability of HM Government s ability to obtain a beneficial impact on underlying cost of funding. CPI-linked gilts, given the acknowledged structural bias within the CPI calculation methodology, would reasonably be expected to trade at slightly higher yields, and require slightly higher coupons ceteris paribus, than their RPI-linked equivalents but the uplifts over the life of the instrument would be commensurately lower. 2. What is the substitutability between potential CPI-linked gilts and RPI-linked gilts? If the Government were to continue only to issue RPI-linked gilts, to what extent would they provide a suitable hedge for CPI-linked liabilities? What are the prospects for CPI/RPI hedging products emerging as an alternative liability management tool to CPI-linked gilts? CPI- and RPI-linked gilts will be substitutes for each other but imperfect ones. While it is likely that some market intermediaries would have an interest in synthesising one class from another we point out that there is uncertainty about the impact of the EMIR directive and its requirements for central clearing of OTC derivatives on the ability of investors to be counterparties to such OTC transactions. In any event, there is no sensible alternative to the Government itself providing primary issuance of CPI-linked securities. 3. If the Government were to issue CPI-linked gilts, how would issuance of these gilts fit into the existing index-linked gilt issuance strategy? What would be respondents preferred split of issuance between RPI-linked gilts and CPIlinked gilts? What maturities or maturity range would be most suitable for hedging CPI-linked liabilities, taking into account the existing range of RPIlinked gilts? 3

4 The legislative changes to CPI-linking of liabilities have already come into effect and hence the potential demand for CPI gilts already exists. This is a step change requiring a significant bias towards CPI-linked issuance. The precise timing of shift of actual demand will, though, depend to a significant extent on terms of mandates given to investment managers and changes to benchmarks. Best estimates of eventual demand seem to imply an approximate split of one-third of total indexlinked gilt issuance to be CPI-referenced and two-thirds RPI-referenced. It is likely that relative demand for CPI- and RPI-linked gilts will vary at different maturities. To the extent that pensions in payment (both now and in the future) under DB arrangements will be disproportionately RPI-linked while deferred entitlements are more likely to be CPI-linked only until retirement, CPI-linked liabilities will tend to be shorter dated than the RPI linked liabilities. Hence there may be a preference, relatively speaking, for shorter dated CPI-linked gilts and longer dated RPI-linked gilts. 4. If the Government were to issue CPI-linked gilts, would respondents who hold RPI-linked gilts ideally prefer to shift a proportion of their portfolio from RPI-linked gilts into CPI-linked gilts? If so, what form might this take (e.g. relevant Government support such as conversion/switch operations)? We think there might well be demand for this in the circumstances envisaged in our answer to Q3. This should be done expeditiously once a market level has emerged. The DMO should look to gauge investor needs and preferences in due course through its regular quarterly consultation process. A possible approach might be to focus on replacing old-style 8-month lagged RPI-linked gilts with new 3-month lagged CPI-linked instruments. Market fragmentation and other risks 5. Would the introduction of CPI-linked gilts detract from the liquidity of RPIlinked gilts or otherwise fragment the index-linked gilt market? How might any such fragmentation be minimised? There is some risk of such fragmentation occurring although, to the extent that the matching requirements of buy-and-hold investors are being addressed through these changes, the detrimental impact on liquidity might not be large. However, if the opportunity is taken to expand index-linked issuance to bring supply and demand more into balance adverse impact on liquidity would be minimised. We think that liquidity in the CPI-linked market would be aided by ensuring sufficient issuance at the outset, in part through judicious arrangements for switching as per our answer to Question 4 and through focusing on the maturity bands where relative demand will be highest. 6. Are there any other issues and risks that the Government should be aware of in launching a new CPI-linked gilt and developing a market for such gilts? If so, how might any such risks be managed? We have no particular comments to make. CPI methodology 4

5 7. Does the possibility of eventual inclusion of owner-occupier housing in the CPI affect the relative demand for a CPI-linked gilt compared with an RPIlinked gilt, and/or the appropriate timing for its introduction? No, we do not think this will be a major consideration as regards ultimate demand for CPI-linked securities. We think that the different (geometric) construction of the CPI index would be the main reason for needing something other than RPI-linked gilts and not just because owner-occupied housing costs are treated differently between the two indices. However, we expect that different treatment of owneroccupied housing costs will make it more difficult for market intermediaries to synthesise CPI-linked investment assets from underlying RPI-linked gilts. Instrument design 8. If the Government were to issue CPI-linked gilts, it is proposing that they would follow the same design as three-month lagged RPI-linked gilts, unless there were a compelling case to make any modifications. Are there any such modifications to instrument design that the Government should consider? In addition, how should any CPI-linked gilts be distinguished from RPI-linked gilts (e.g. in the naming convention). Please state the rationale for your comments. We do not have any modifications to suggest regarding instrument design but, rather, we consider that they should mirror the design of RPI-linked gilts unless there is a compelling reason to the contrary. CPI-linked gilts should follow the same format as the 3 month lagged RPI-gilts which are currently being issued and any features such as no principal floor being replicated precisely. Any disparities would make comparisons between the two styles complicated and would potentially create difficulties in the accompanying swaps markets. We agree that the opportunity should be taken to find a convenient and obvious means of distinguishing the two types of instrument through the naming convention. In times past the protocols regarding nomenclature led to a kaleidoscope of names in the gilts market (Treasury, Exchequer etc.) even though the distinctions were of limited, if any, practical relevance for investors in the instruments concerned. It might be convenient, in this instance for practical purposes of benefit to market participants, to consider a limited revival of that approach. 9. If the Government were to issue CPI-linked gilts, do respondents agree with the Government s proposal not to make subsequent adjustments to the nominal value and/or coupon payment on CPI-linked gilts to take account of any revision in the CPI following its original publication? In addition, do respondents agree with the Government s proposal that accrued interest should be calculated using the first publication of the CPI, regardless of any potential later revisions? We see no reason not to align the new instruments features in all respects with the arrangements applicable to current issuance of RPI-linked gilts. Lead time for implementation and inaugural issuance 5

6 10. If the Government were to issue CPI-linked gilts, when should the first issuance be? What would be the lead times required by investors, primary dealers and other interested stakeholders? The shift to CPI-linking of liabilities has already come into effect pursuant to the Government s legislative changes. We therefore believe that the DMO should initiate issuance of the new instruments at the earliest practical opportunity. 11. Is there a preferred maturity point at which the Government should focus any initial issuance of CPI-linked gilts? We suggest starting with one long- and one shorter-dated stock that would be suitable to be built up into benchmark stocks with subsequent in-filling at other maturities. A possible approach would be to issue one 10- and one 20-year instrument at the outset with the next step being one 15- and one 25-year instrument. ABI 22/9/11 [s:\inv\consultations\other domestic\2011 6