By William Nicoll
What do you do when the gap between your inflation-linked assets and liabilities just gets bigger and bigger? The last time we totted up the figures, UK pension funds and insurance companies faced some £3trn worth of liabilities much of which is linked to UK inflation. There is no hard and fast, empirical data here but the point is that inflation-linked liabilities dwarf the traditional pot of inflation- linked assets used to match them: the £300-odd billion UK index-linked gilts market.
Institutions have often sought to fill this gap with asset classes whose returns have offered some correlation with inflation, namely equities and commodities.
Some call these assets inflation hedges. That’s interesting because, in the right hands, they obviously can produce attractive returns over the long term but they also have a lot of unpredictability and volatility. More importantly there are periods where the performance is so far away from inflation that only the strongest investors would keep their nerve and hold them. Gordon Brown’s sale of the UK gold reserves demonstrates that even the least pressured investor is likely to be subject to fashionable thinking at some point.
Investors who want a quieter life should turn to assets with a legal obligation to pay inflation-linked returns – what we call ‘contractual inflation’. These could include corporate bonds, property leases or ground rents, housing association loans and infrastructure debt.
An obvious option is public debt issued by companies in sterling, that pay a coupon linked to the retail prices index. They may not be as liquid as corporate bonds offering a fixed income but then many buyers in this market aren’t after the liquidity – just the long-term income stream. Issuers tend to be the usual suspects in the supermarket and utility sectors, who want longterm funding and whose businesses have a long-term link to inflation.
Another option is good quality UK real estate where the tenant has signed a contractual agreement to pay a rental stream for decades that rises each year in line with inflation. The investor receives a return akin to an inflation-linked bond, with the added security of owning a diversified pool of real estate that could grow – models indicate that even if the real estate fails to grow the total returns are comparable with the direct returns available on bonds issued by the tenants.
The UK has a niche ground rents market made up of the contractual payments that a building’s tenant or leaseholder are required to make to their freeholder. While not particularly liquid, they are more senior in a property funding capital structure than even mortgage investments and can be linked directly with inflation but are difficult to source.
The UK’s housing associations used to borrow almost exclusively from banks or corporate bond markets. Now that banks are unable or unwilling to provide the sort of 20, 30 or even 40-year funding these associations require, the opportunity to step in exists. Some institutions are doing it and one has already provided over £1bn of capital to the sector in the last year alone – while not all lending here is inflation linked, the market is so large that even a small proportion will offer opportunities for investors.
Lastly, the infrastructure private lending market looks like it is starting to thaw. Although many of these loans are still locked away in bank vaults and new deals remain few and far between, there is increasing regulatory and economic pressure on banks and governments to act. As an example, institutions recently stepped in to finance and develop a new hospital in Liverpool – and more loans will come, again largely on an inflation-linked basis. Many of these ‘contractual inflation’ assets are already available to institutions, which are finding attractive pricing and high levels of security.
While these investments are rarely liquid and many of the deals can’t be picked off the shelf, they are a good place to start for any institution that wants to avoid volatile asset classes.
William Nicoll is director of fixed income at M&G Investments
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