Market Economics | Interest Rate Strategy - BNP PARIBAS ...

averaging introduces sizable upside bias (0.5%)
relative to the ‘geometric’ CPI. Over 10 years, we find
the RPI/CPI spread averages 71bp vs. 54bp over the
past 20 years but is very sensitive to the start
date/period. Assuming CPI is 0.75% below RPI (on
average) and all private sector pension funds switch
to CPI (unlikely) – we see a maximum impact on the
net funding position in the region of £70bn (which
would be similar to the benefit from PPF’s actuarial
changes in Oct-09). With many private pension funds
unlikely to be included in CPI indexation bracket, at
least in the current state of legislation, the use of
AER (instead of SVR) in MIPS and the encapsulation
of housing related prices eventually in CPI suggest
the gap could be lower over time (subject to a likely
lower bound of 0.50% from formula effect). We
expect the realised impact on aggregate PFs’ net
asset/liability to be closer to half this amount (around
£30-40bn). However, optionality in indexation of
pensions (caps and floors) and maximum of (CPI,
RPI and cap) in cases where the Trust Deed
specifies RPI but is subject to the statutory minimum
requirement (CPI), complicates the issue and under
certain assumptions could even increase pension
fund liabilities (according to Redington).
Market downplays Risk of Switch to CPI
Understandably, the announcement from Steve
Webb triggered a correction in (long-end)
breakevens. Uncertainty over the impact on private
sector PFs could cause LDI programmes to be
scaled back or placed on hold, weighing further on
breakevens (and liquidity) near-term as sovereign
supply continues. That said, greater net asset/liability
positions (lower deficits/higher surpluses) tend to
encourage LDI hedging and as a consequence are
associated with higher long-end breakeven levels –
Chart 4. In fact, certain LDI related counterparties
have actually increased RPI exposure following the
initial setback against our expectations although
flows are reversing after the UKTi-22 auction.
In Table 2, we estimate LDI demand using the
duration gap (or shortfall) between aggregate PF
assets and liabilities (from PPF data) using typical
actuarial assumptions and liabilities. With respect to
supply, we duration-weight the total market
capitalisation of GBP sovereign and corporate bonds
for both nominal and index-linked markets. Finally,
we combine our demand/supply analysis to gauge
the adequacy of inflation supply to meet pension
funds’ requirements. Relative to the market
capitalisation of outstanding GBP linkers (all RPIlinked),
demand outstrips outstanding market
capitalisation by more than 3 times (compared to
1.15 for nominals). We estimate at least GBP 110bn
(or 57%) of the GBP linker market (by market
capitalisation) is held by DB pension funds (at end-
March 2009) based on Purple Book 2009 – Table 3.
Table 1: Sensitivities of PF Deficits to Changes
in Assumptions & Market Prices
20
15
10
5
0
-5
-10
Change in Asumption
Impact (as of Mar-09)
Approximate Cash
Impact on Deficit
↑ Longevity by 2y ↑ 5% in Liabilities ~ £45bn
↑ Inflation by 0.1% ↑ 1% in Liabilities ~ £9bn
↓ Discount Yield by 0.1% ↑ 2% in Liabilities ~ £18bn
↓ Discount Yield by 0.1% ↑ 0.4% in Assets ~ £3.5bn
↓ Equities by 1% ↓ 0.4% in Assets ~ £4.4bn
1% ? Discount Yield = 40% ? in Equities
Chart 3: UK RPI – CPI y/y vs. Housing RPI
% RPI-CPI yoy
%
25
4
RHS
RPI Housing yoy
-15
Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08
Chart 4: Aggregate Private PF Surplus vs. 15y+
UK Cash Breakeven
200000
160000
120000
80000
40000
0
-40000
-80000
-120000
-160000
-200000
Aggregate PF Surplus (PPF, 7800)
15y+ Gilt BE
-240000
Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10
Table 2: UK PF ALM Gap vs. Bond Market
UK Private Pension A/L Structure
Assets (£, bn) Liabilities (£, bn) Surplus / (Deficit) (£, bn)
Duration 5 18
Nominal (bn) 901 923 -21.8
Risk 4507 16619
Duration Gap -12112
Hedge 20y Equivalent 673
Mkt Cap 20y Equiv. (Nominal)
Demand/Supply Ratio
582
(Sov + Corp Nominal Bonds)
116%
Mkt Cap 20y Equiv. (Linkers)
Demand/Supply Ratio
212
(Sov + Corp Index-linked Bonds)
318%
Table 3: PF Asset Allocation & BNPP Estimates
Asset Allocation 2007 2008 2009
Equities 59.5% 53.6% 46.4%
Gilts & Fixed Interest 29.6% 32.9% 37.1%
Insurance Policies 0.8% 1.1% 1.4%
Cash & Deposits 2.3% 3.0% 3.9%
Property 5.2% 5.6% 5.2%
Other Investments 2.5% 3.8% 4.5%
Detail Equity & Bond Holdings
Weighted Average Share
(2009)
Approximate
Holdings
3
2
1
0
-1
-2
-3
-4
4.0
3.6
3.2
2.8
2.4
2.0
Proportion of
Mkt Cap.
Gilts & Fixed Interest
UK Gilts 29.0% 98.6 16.8%
Corporate Bonds 38.3% 130.2 28.2%
Index-linked Gilts 32.6% 110.8 57.1%
Equities
UK Equities 44.2%
Overseas Equities 53.8%
Sources: Purple Book 2009, The Pensions Regulator, BNP Paribas
Herve Cros/Shahid Ladha 16 July 2010
Market Mover, Non-Objective Research Section
41
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