Yet again, this week has further demonstrated the UK Parliament's inability to decide what to do about the Brexit referendum result. Whilst the toing and froing of parliamentary votes and sparing across the dispatch boxes was taking place, there was an additional non-Brexit related announcement which has created a shift in part of the UK market. Sajid Javid is launching a consultation on bringing the Retail Price Index (RPI) closer to the Consumer Price Index (CPI) between 2025 and 2030. Index-linked Gilts are linked to RPI which includes more housing costs and has generally been higher than the CPI rate. The proposed adjustment hit long dated index linked bonds, with the 50 year bonds dropping as much as 10% at one stage on Wednesday. Shorter dated bonds were relatively unmoved, given the rationalization period, meaning the FTSE UK Index Linked All Stocks index was down 4.3% on the day.
Defined benefit pension schemes have traditionally used RPI to guide benefits, but in many cases have been trying to switch to CPI to reduce their liabilities. The government has carefully selected which measures to use, with benefit increases linked to CPI but charges often linked to the higher RPI .For rail commuters the change in RPI will eventually be welcomed news. If CPI rather than RPI had been used, since 1995 my season ticket would be 17% or £800 cheaper than it was when I renewed it in July. While RPI has been around much longer, and is the headline figure commonly used by the press, CPI has been the chosen measure used by economists due to its preferred methodology. The Bank of England has always had a 2% CPI target and the resulting monetary policy changes are based on this measure, so keeping contracts linked to RPI has been questioned for some time.
A similar change to RPI was suggested around 2012/2013, but was rejected by the Office of National Statistics. At that time, index-linked gilts had a period of underperformance, but when it became clear the move would not happen, the index rallied by over 4% in a day.
There has been pressure building for some time for this move, and now it looks more likely to evolve. To bring the RPI more in line with the CPI will involve a long process, and the proposal is to phase it in between 2025 and 2030. As a result, shorter dated bonds look relatively immune to the changes, but the sell-off in long dated bonds is unlikely to be reversed any time soon. The FTSE Index-linked benchmark is on average very long dated. We therefore prefer taking exposure through shorter dated bonds and funds that can control the risks around longer dated exposure.
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