Are CPI-linked bonds the next big thing in pension investment?

Pension liabilities are increasingly moving away from the retail price index (RPI), with the High Court last year confirming earlier rulings that the consumer price index (CPI) could be used to calculate pension increases.

Switching to CPI reduces the size of liabilities, but makes it harder to find matching assets, however, because all UK bond issuance has historically been linked to RPI.
That changed when Greater London Authority (GLA) issued the country's first CPI-linked bond in May, with Rothesay Life the sole investor. This landmark moment was followed by issuance from Warrington Borough Council and the Church of England Pension Board, with the latter invested in by Pension Insurance Corporation.

A better match
There is a clear regulatory incentive for pension insurers to invest in these bonds, but it could also make sense for big pension schemes.

Sharpe Actuarial director James Sharpe says: "Under Solvency II pension insurers with internal models may hold capital for mismatch of assets and liabilities, or basis risk. CPI-linked pensions are better matched by CPI-linked bonds than RPI-linked bonds, and should help pension insurers reduce their Solvency II capital requirements. I see no reason why large pension schemes would not also consider CPI-linked bonds to match their CPI-linked liabilities."

As the number of potential borrowers with revenues linked to CPI continues to grow - which will almost certainly happen given RPI is no longer considered an official statistic by the Office for National Statistics - this will result in higher interest in issuing CPI-linked bonds. A big game changer would be the government deciding to issue CPI-linked gilts as well as RPI-linked gilts.

Lloyds Bank Commercial Banking capital markets managing director Glenn Forbes says since the GLA transaction which his team led, there has been a "major step change" in discussion around CPI-linked issuance. "Right across the board we are seeing increasing interest in CPI-linkage. The recent transactions have alerted institutions to additional opportunities making them rethink their hedging of inflation-linked exposures. With the growth of CPI borrowing there's an opportunity for more efficient hedging of inflation-linked pension liabilities," he says.

He adds that several pension advisers are showing "a lot of interest" in CPI-linked bonds.

Issuers are likely to come mostly from the public sector - as is already the case with RPI issuance - as councils look at alternatives to the traditional funding route of the Public Works Loan Board.

Buck Consultants investment consultant William Parry argues it would be easier to assess the credit quality of a public sector body that has government backing than a corporate.

It also helps if the bond is similar in structure to RPI-linked debt that schemes are already used to. This was the case with the GLA's bond which used indexation methodology in keeping with international standards that most inflation-linked products follow.

Forbes says: "As the CPI market goes up, it will likely build off the RPI model so that it's a simple case of substituting RPI for CPI. So although this is new, the underlying technology is very familiar to most pension funds and their asset managers. They probably just need to look at the price difference of RPI to CPI and judge whether it presents good value."

A big leap
It would be a big leap to see it as a practical investment solution, however. There is only non-standard issuance so far - bypassing the public market - which only suits very large funds.

PIC's head of debt origination Allen Twyning says: "It's a lot of work, not only understanding the investment but the documentation that comes with it, the valuation approach, and how you apply internal rating to the asset. It's about having sufficient scale and expertise to be able to do that."

Schemes would need to look at the liquidity and size of the bond issue and also the credit quality of the borrower, says Sharpe.

It would also require a fair amount of work by the scheme actuary and a close look at which inflation measures the scheme is exposed to.

Parry says the aim would not be to replace all of a scheme's RPI-linked investments with CPI ones.

Many liabilities are still linked to RPI, and not all schemes can move to CPI with estimates suggesting that around half can make the switch. Some have rules specifying benefits must be increased in line with RPI, while others have just say a statutory measure must be used.

Practical issues
Parry says although there will be demand from schemes, there needs to be much more issuance to turn it into an accessible asset class. "When you actually look at the practicalities and the proportion of liabilities now linked to CPI, unless there's a highly accessible investment, most schemes will struggle to get on board."

Over time a structure could be created to make it easier for schemes to access these esoteric bonds. This would require many more bond opportunities - Parry says around 50 to 100.

He believes demand will be similar to that seen for longevity swaps: "It can be a good idea as it can take risk off the table which companies like, but how accessible they are to trustee boards is a very different question. The concept is great but practical issues get in the way a bit."

Forbes says these markets develop slowly but he is optimistic about the long-term prospects: "The pensions industry is long term and quite rightly decisions are not made rashly and tend to go through various levels of approval. We're not dealing with an asset class that people should expect to take off overnight. In the near term we will see a continued trickle of CPI; there is potential for it to become very common indeed but other things would have to happen."