On the go: The announced reform of the retail price index, to match the consumer price index including housing costs, saw inflation hedging rise by six per cent quarter on quarter at the end of September 2020.
The latest iteration of the BMO Global Asset Management survey showed that prior to the reform’s announcement in November, buyout activity slowed and inflation hedging decreased, proving true the long-standing prediction that the reform would release pent-up demand.
Pensions Expert reported at the time on the 16 per cent quarter-on-quarter fall in last year’s third quarter, reflecting ongoing concerns about the precise nature of the expected reform.
Inflation hedging had fallen to approximately £34.4bn in the third quarter, but rebounded to £36.5bn in the fourth quarter, according to the survey.
Switching activity increased immediately prior to the announcement as some market participants banked on the prospect of compensation for index-linked gilt holders, though the reform in the end made no such allowances.
Nevertheless, the expectation pushed gilt inflation break-evens to “extreme levels” versus swaps, triggering “contrarian or dynamic investors” to oppose the move, the survey found.
“Together, these made a significant contribution to overall inflation trading over the quarter.”
Interest rate hedging remained high in the third quarter, but fell by three per cent to £41.8bn in the fourth quarter, the survey showed.
According to Rosa Fenwick, liability-driven investments portfolio manager at BMO Global Asset Management, the fourth quarter “brought a resolution to the long-standing question around RPI reform, with the switch to CPIH occurring in 2030 with no compensation”.
“While the result of RPI reform was largely anticipated by the market, this likelihood was only partially priced in,” she said.
“On the face of it, this news was expected to cause long-dated RPI rates to fall. Instead, the impact of pent-up demand and lack of supply turned this on its head as investors piled into RPI once the uncertainty had been resolved.
“While the wedge between CPI and RPI decreased as expected, instead of RPI moving closer to CPI, RPI acted as the anchor.”
The survey, which asked investment bank derivatives’ trading desks for their predictions for pension scheme liability hedging for the year ahead, found most respondents expected higher inflation and nominal yields, though predictions for the outcome of real yields “are more nuanced”.
