"RPI R.I.P"
20 January 2006
No. 229
Newton Global Fixed Income Strategy
Reducing UK index-linked exposure
For those still clinging to the wreckage of the idea that the inflation-linked bond market bears any resemblance to real economics, sanity or morality, we thought an update following this week's 'shenanigans' in the UK gilt market, might be in order. For those that missed it (it must be true - it made the front page of the Financial Times), long-term bond yields in the UK were driven to all-time lows as asset allocators filled their portfolios, sending real yields below 0.5% for 50-year maturity index-linked bonds. The resulting yield curve compared to other global markets can be seen in Figure 1. It makes pretty ugly viewing. The effect on implied or break-even inflation rates is just as savage 1 . With the UK currently running an inflation rate of around 2%, owners of index-linked bonds are guaranteed losers unless there is a burst of inflation that only a few see lurking around the corner. For a variety of reasons, we don't see this happening.
Datasource: Bloomberg
Just to hammer the point home here, we have performed the following calculation on all the available inflation-linked markets in the world. On all kinds of measures, the UK index-linked markets offer the worst value of all (see below).
Datasource: Bloomberg
Obviously, the inflation-linked market in the UK has divorced itself from any kind of reality and no one should be in any doubt that bond markets aren't merely an extension of economics - they are driven as much by supply and demand as anything else. For this reason alone, we are reducing our exposure to index-linked bonds until some sanity returns to the situation.
The views and opinions contained in this document are those of Newton Capital Management Limited at the time of going to print and should not be construed as investment advice. In the U.S. services from Newton Capital Management Limited are available from Newton Capital Management LLC. Newton's registered office is located at: 1209 Orange Street, Wilmington, DE 19801. Newton Capital Management Limited is an investment management firm authorized and regulated in the United Kingdom by the Financial Services Authority in the conduct of investment business and is a wholly owned subsidiary of Mellon Financial Corporation Inc. Registered in England no. 2675952. 'Newton' refers to the Newton group of companies that includes Newton Investment Management Limited, Newton Capital Management Limited, Newton International Investment Management Limited and Newton Fund Managers (CI) Limited.
Please remember that the value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested. Past performance is not a guide to the future. The value of overseas securities will be influenced by fluctuations in exchange rates.
The information contained in this document should not be construed as a recommendation to buy or sell a security. It should not be assumed that a security has been - or will be - profitable. There is no assurance that any security will remain in a portfolio.
A Mellon Financial Company SM
