Index-Linked or Conventional Gilt for a Deficit
The trustees of the Harlow Print Pension Scheme must choose between two 12-year sterling bonds for an £85 million liability-matched portfolio. The liabilities are linked to CPI. A conventional gilt yields 4.75% to maturity. An index-linked gilt of the same maturity has a real yield of 1.05%. CPI is currently 4.6%; the scheme's economist forecasts 3.2% next year and 2.6% thereafter, but warns that the forecast error is wide. The Bank Rate is 5.25%, and the market is pricing two cuts within 12 months. The scheme has a deficit of £6 million and a 70% funding ratio. The investment consultant says the scheme should 'lock in' the index-linked real yield because it matches liabilities, while the treasurer favours the conventional gilt because its 4.75% coupon is higher and the scheme needs cash flow. The trustees must decide before the next valuation.
1. Calculate the approximate breakeven inflation rate from the two yields and explain what it implies for the trustees.
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The simple breakeven is the nominal yield minus the real yield: 4.75% - 1.05% = 3.70 percentage points. A more precise calculation is (1.0475 / 1.0105) - 1 = 3.66%.
This is the average CPI inflation rate at which the two bonds would produce the same nominal return, ignoring tax, liquidity and risk differences. If CPI averages above about 3.7%, the index-linked gilt does better in nominal terms; if CPI averages below that, the conventional gilt does better.
The economist's central forecast is 3.2% then 2.6%, which is below the breakeven. On that forecast, the conventional gilt would win on nominal return. But the breakeven is not the only issue. The scheme's liabilities are CPI-linked, so the index-linked gilt also reduces surplus risk. If inflation surprises on the upside, the conventional gilt's real value falls while the liabilities rise. The trustees should therefore treat the breakeven as a starting point, not a complete decision rule.
2. The treasurer favours the conventional gilt because of its higher coupon. Recommend a decision, taking account of the scheme's deficit and liability linkage.
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The treasurer is focusing on cash flow, but the scheme's problem is a £6 million deficit against CPI-linked liabilities. A conventional gilt creates inflation mismatch: its 4.75% coupon looks higher, but its real value is eroded if CPI runs above expectations.
Illustrative outcomes at 3.0% CPI: the index-linked bond's nominal-equivalent return is approximately (1.0105 x 1.03) - 1 = 4.08%, below 4.75%. At 4.5% CPI, it is approximately (1.0105 x 1.045) - 1 = 5.60%, above 4.75%. The breakeven of about 3.7% is close enough to forecast uncertainty that the decision is not obvious on return alone.
Recommendation: allocate a majority to the index-linked gilt because it matches the liability driver and locks a positive real yield of 1.05%. Retain some conventional gilt for cash flow and diversification, and model scenarios at 2%, 3.7% and 5% CPI. The trustees should document that the decision is driven by liability matching, not by the highest coupon.