Despite demand from pension schemes, issuance of ultra-long index-linked gilts has been sparse. We therefore believe the real question here is about economics and whether the Debt Management Office (DMO) is willing to issue in this sector.
It is fair to say that in recent years, the UK government has not been active in issuing index-linked gilts in the ultra-long sector. There was an 18-month void in issuance of any index-linked gilts longer than 35 years between January 2019 and mid-2020. And if we look at issuance in the 45-50 year sector, the lack of supply persisted for nearly four years (between February 2017 and January 2021).
Despite this lack of supply, however, implied inflation in the ultra-long end underperformed other sectors on the curve. Figure 1 outlines the difference between 30y20y forward (20y inflation 30yrs forward, i.e. inflation between 30 years and 50 years) and 15y15y forward gilt implied inflation (i.e. the relative price of ultra-long versus long inflation) and also shows the volume of index-linked gilt issuance (illustrated by the size of the spheres).
When 30y20y minus 15y15y reduces, as can be seen in the trajectory of the black line in Figure 1, this means 30y20y is underperforming.
Why did the ultra-long sector underperform?
Many have explained this underperformance as being due to factors such as the ‘pension freedoms’ and revision in actuarial assumptions, specifically on longevity. Because of the contractionary impact upon pension liabilities, it is thought that many pension schemes saw a one-off reduction in their need to hedge their inflation-linked liabilities in the same period, creating ‘invisible’ supply in the secondary index-linked gilt market. Our colleague Rob Pace wrote on the topic recently.
Are we at a turning point?
But the effect of such one-off events will have to fade.
From the start of the year to the end of June, there was strong performance in ultra-long dated index-linked gilts, with the IL48/IL68 spread flattening by around 15 basis points. This demonstrated renewed demand from investors for ultra-long index-linked gilts, further evidenced by the price movements following the most recent auction of the 2065 index-linked gilt (23/06). Since the start of July, however, this has re-steepened, possibly due to idiosyncratic flows.
The strong performance of ultra-long dated index-linked gilts and latest resumption of DMO supply in the sector has rekindled discussion for a new 50-year benchmark index-linked gilt. The last extension to the index-linked gilt curve occurred in 2013, with the issue of the 2068 index-linked gilt.
The fact that there is a liquid conventional gilt 2071 should provide the DMO with a good position from which to consider extending the index-linked curve. Looking at the outstanding nominal, the current preferred 50-year index-linked gilt to tap is the 2065 issue, which is approaching the typical outstanding nominal DMO targets in that sector, which adds to the reasons why consideration of a new 50-year benchmark index-linked gilt might be around the corner.
Will we see 50-year index-linked gilt supply before the 10-year anniversary of the launch of the 2068 index-linked gilt?
In summary, why wouldn’t the DMO issue?
Possible reasons include:
• Price, i.e. if the DMO were to issue too cheap relative to the 2068 index-linked gilt, the value to the UK Treasury may be questioned.
• Long-term demand. The future impact of COVID-19 on longevity is uncertain, as Ben discusses here. The DMO may have some concerns about another bout of ‘invisible supply’ in 2022 and onwards.
• Desire from the Treasury to reduce inflation-linked issuance– in financial year 2015/2016, the proportion of issuance was 26% versus a projected 11% in the 2021/2022 financial year.
• Inflation accrual. High potential inflation figures over the next few years could be compounded for longer if the average duration of issued index-linked gilts rises.
Our view, however, is that there is natural demand, there is evidence of actual demand coming through this year, and that 50-year index-linked gilts should perform better than alternative 50-year real asset hedges. We will be providing our thoughts to the DMO and watching closely for the decision.
 “At Budget 2018 – and as part of the government’s responsible approach to fiscal risk management – the government announced that it would look to reduce the proportion of index-linked gilt issuance in a measured fashion as a means of reducing its inflation exposure in the debt portfolio.” Source: DMO