UK prepares 50-year linker

New angles

Demand from pension funds and banks has prompted the UK Treasury to prepare the first-ever 50-year inflation-linked bond. "Through our informal talks with our stakeholders, banks and other market participants we were told there is likely to be sustainable demand for ultra-long gilts in both index-linked and conventional formats," says Arnaud Marès, head of portfolio strategy at the UK Debt Management Office (DMO).

Demand for 50-year index-linked and conventional gilts could potentially be £15 billion–20 billion a year, according to responses to consultation held by the DMO. Much of that demand is likely to come from pension funds, which are currently over-hedged in the 25- to 30-year sector and are looking to move along the curve to better match their assets and liabilities. Demand is also expected to come from banks looking to hedge their inflation swap books. "This issue should be in demand. You've got banks using their balance sheets to provide inflation hedges longer than the government curve, and banks should be natural buyers to hedge these existing positions," says Chris Thomas, head of sterling inflation at Royal Bank of Scotland (RBS) in London.

The ultra-long linker will be auctioned on September 22. Previously, a 30-year linker was the longest-dated inflation-linked bond available in the gilts market. The UK Treasury issued its first 50-year nominal bond in May and tapped it in June. "The DMO is trying to weight its issuance aggressively towards the back end on the basis that it's cheap funding," says Thomas.

"We have a policy of issuing bonds that achieve a liquidity in the market, so we will expect to be building up any bond to benchmark size," says Marès. After the first 50-year linker issue, the DMO will seek feedback from the market and make a decision concerning further issuance on a quarter-by-quarter basis. It is expected that once the 50-year linker is launched, the Treasury may issue 40-year conventional bonds and linkers to fill the gaps in the yield curve between 30 and 50 years.

One possible hurdle is the high cost of inflation protection. RBS's Thomas believes that, while the high breakeven inflation rate (the spread between nominal yields and real yields, representing expected inflation plus a risk premium) could be problematic for the Treasury, the levels are an indication of the strong demand for inflation-linked assets. Thomas argues that the launch of the 50-year linker will allow pension funds to re-hedge their liabilities by locking in stock market gains and redeploying profits into safe assets. "That safe asset also supplies investors' inflation hedge because these bonds are, in terms of coupon and redemption amount, fully inflation-protected," he says.

Pricing-wise, dealers are looking at a three-pronged approach. Most think a combination of breakeven relative to the nominal 50-year bond, a real yield basis and an asset swap basis will reveal the best price for the new linker. "We're trying to look at the shape of these curves and what they reveal about the market's expectations for the pricing of convexity," says Thomas. What remains to be settled is whether the 50-year linker will come out as an auction or a syndicated deal.

Rachel Wolcott

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