TIPS (Treasury Inflation Protected Securities) are US inflation-linked bonds, but should they also play a role in UK defined benefit (DB) schemes’ portfolios? Our new research challenges some conventional assumptions about inflation hedging a DB scheme, and explains how TIPS could help reduce risk as well as boost returns.
It’s often taken for granted that UK DB schemes are best inflation hedged using only UK inflation-linked bonds. We agree – perhaps combined with UK inflation swaps in a liability-driven investment mandate – if the liabilities are linked to the retail price index (RPI).
However, a significant proportion of UK scheme liabilities are now linked to the consumer price index (CPI). Indeed, some schemes – such as the Local Government Pension Schemes – have liabilities that are 100% linked to CPI.
UK linkers can be a surprisingly poor hedge for CPI-linked liabilities due to wedge risk. Although we know TIPS aren’t a great inflation hedge for CPI liabilities either, we investigated whether they could complement UK inflation-linked bonds. Our full findings are contained in our new research paper, but we wanted to share some highlights here too.
Based on correlations and volatilities derived from data covering 1988-2018, we looked to see what mix of UK inflation-linked bonds and TIPS would minimise volatility for a scheme with CPI liabilities. We found the mix was around 60% UK inflation-linked bonds and 40% TIPS. That’s admittedly a very substantial allocation to TIPS, and comes with some strong caveats, including the risk of being misled by recent data that’s relatively benign. Overall, though, we think there is a case for including some TIPS exposure in the hedging portfolio of a scheme with some CPI-linked liabilities. We might also consider European inflation-linked sovereigns; in our paper we focused only on TIPS for illustrative purposes.
We also consider the role of TIPS from the perspective of enhancing returns. Comparing market-implied inflation with central-bank targets suggests that UK linkers are expensive compared with their US counterparts, likely driven by demand from UK pension funds. Swapping some linkers for TIPS can offer a diversifying source of return, even for schemes with RPI-linked liabilities.
Our new paper sets out all this analysis in greater detail, so please take a look!
Last year was driven more by investor behaviour than the market cycle. In the Asset Allocation team we try to understand this behaviour, often taking contrarian positions to deliver results for our clients.