Bond investors accept credit and market risk but one thing that’s far less easy to stomach is unilateral changes to terms and conditions. And from what I see that’s what could happen in the index linked gilts market. Linkers are adjusted by the Retail Price Index but proposals may mean that the RPI is replaced with a Consumer Price Index. The CPI rate is about 0.5%-0.90% lower than the RPI. If it went ahead this is a materially adverse change for holders of linkers. There are two issues.
Is the CPI a better measure of inflation? Debateable but statisticians seem to be of the opinion that that it is.
Should existing RPI linked gilts be re-linked to CPI? Clearly not. Investors have bought these bonds in good faith and expect the UK Government to act in a similar manner. Not restructure the debt post issue. Changing the linking is tantamount to cutting the coupon and reducing the par redemption amount on a conventional Gilt. Countries that restructure debt do so because they are forced to do it. It amounts to sovereign default. If the UK government follows this path it sends a very poor message to investors. It means that Gilt holders are taking on more risk than they thought. Could HMG undermine investors again? Probably. Indices used to calculate payments need to be transparent and not subject to manipulation otherwise mistrust reigns. It’s ironic that commercial banks received a hammering on Libor fixing wasn’t that to do with manipulation too? Do you think we would be discussing this if CPI exceeded RPI? No. It’s all about reducing debt servicing costs. This is short sighted. As we know yields rise with uncertainty and that’s what will happen. Far from cutting costs it will add a risk premium to the whole Gilt market. The solution? Outstanding debt should retain RPI as it is currently calculated even if CPI is adopted elsewhere.
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