Money matters
Entertaining times in the gilts market. About 18 months ago I went to a day's seminars on asset management (oh what an exciting life I lead). The man in charge of fixed interest investments at Threadneedle gave a talk and observed that index-linked gilts, which had been rather popular over the previous nine months, might be at their peak.
Well, he was slightly wrong.
A bit of background. Suppose you have a lot of money now and suppose that you want to invest it to cover liabilities that will appear 30 years down the line. In other words, suppose you are a fund manager for a pension scheme. Now, fund managers, not being the brightest of beasts and being particularly keen on "doing what the others are doing", notice that index-linked gilts are getting popular. The reason is not hard to find and can be linked to the recent increase in the price of gold in spite of the dollar being strong. People are finally sussing that inflation, far from dead, may well make a reappearance, if not sooner, then at least in the medium term.
Unfortunately, knowing or even suspecting that something is going to happen doesn't necessarily do you much good. You have to know what to do with the information. For the fund managers, they could see no more than "buy index-linked".
This would be fine if there were a limitless supply, but there isn't. The 2055 issue now offers a real yield of only 0.48 per cent - at one point this week it was 0.38 per cent. This compares with the 1.1 per cent at which the bond was issued last year and the 2 per cent at which most index-linked offers were made. Now, a return of inflation plus 0.38% is basically costing you money (for the same reason that the guarantee that pensions will go up with inflation rather than in relation to earnings inevitably means that pensioners get poorer -- real output increases and we get wealthier in real terms).
Now, one could argue that the 0.38% might look bad, but if the rest of the investment market is going to collapse, it might be good (also known as the "mattress investment fund", which in an idle moment I half-heartedly thought of launching. "Give me your cash and I guarantee you the same amount back in five years, no matter what happens to the markets").
However, this line of argument collapses in the face of the fact that Treasury Income Protected Funds (Tips) — the US equivalent of UK index-linked gilts — are offering 2%, what one might call the "proper" risk-adjusted rate.
In other words, the return on UK index-linked gilts is so low because a large number of rather stupid people (who are paid far too much), are buying them like sheep, thus pushing up the price. That doesn't mean that the price will fall in the near term (although it does make them a bad investment in the medium to long term). As in poker, the short-term in the markets is longer than you think. But Chris Fellingham, managing director of fixed income at Merrill Lynch Investment Managers, summed it up right earlier in the week when he said that it is perfectly sensible for pension funds to look at asset-liability matching but they should make some sort of valuation judgment before buying index-linked bonds.
Which could turn out to be one of the financial understatements of the year.
Now, what I would like to know is, how can one exploit this disconnection between UK index-linked offerings and the US Tips? There has to be a way, but I just can't see what it might be. God, I thought that there was a derivative for everything these days?
Well, he was slightly wrong.
A bit of background. Suppose you have a lot of money now and suppose that you want to invest it to cover liabilities that will appear 30 years down the line. In other words, suppose you are a fund manager for a pension scheme. Now, fund managers, not being the brightest of beasts and being particularly keen on "doing what the others are doing", notice that index-linked gilts are getting popular. The reason is not hard to find and can be linked to the recent increase in the price of gold in spite of the dollar being strong. People are finally sussing that inflation, far from dead, may well make a reappearance, if not sooner, then at least in the medium term.
Unfortunately, knowing or even suspecting that something is going to happen doesn't necessarily do you much good. You have to know what to do with the information. For the fund managers, they could see no more than "buy index-linked".
This would be fine if there were a limitless supply, but there isn't. The 2055 issue now offers a real yield of only 0.48 per cent - at one point this week it was 0.38 per cent. This compares with the 1.1 per cent at which the bond was issued last year and the 2 per cent at which most index-linked offers were made. Now, a return of inflation plus 0.38% is basically costing you money (for the same reason that the guarantee that pensions will go up with inflation rather than in relation to earnings inevitably means that pensioners get poorer -- real output increases and we get wealthier in real terms).
Now, one could argue that the 0.38% might look bad, but if the rest of the investment market is going to collapse, it might be good (also known as the "mattress investment fund", which in an idle moment I half-heartedly thought of launching. "Give me your cash and I guarantee you the same amount back in five years, no matter what happens to the markets").
However, this line of argument collapses in the face of the fact that Treasury Income Protected Funds (Tips) — the US equivalent of UK index-linked gilts — are offering 2%, what one might call the "proper" risk-adjusted rate.
In other words, the return on UK index-linked gilts is so low because a large number of rather stupid people (who are paid far too much), are buying them like sheep, thus pushing up the price. That doesn't mean that the price will fall in the near term (although it does make them a bad investment in the medium to long term). As in poker, the short-term in the markets is longer than you think. But Chris Fellingham, managing director of fixed income at Merrill Lynch Investment Managers, summed it up right earlier in the week when he said that it is perfectly sensible for pension funds to look at asset-liability matching but they should make some sort of valuation judgment before buying index-linked bonds.
Which could turn out to be one of the financial understatements of the year.
Now, what I would like to know is, how can one exploit this disconnection between UK index-linked offerings and the US Tips? There has to be a way, but I just can't see what it might be. God, I thought that there was a derivative for everything these days?