Stressed pension funds urge UK to sell more inflation-proof debt

By Abhinav Ramnarayan

LONDON (Reuters) - Pension funds are pushing the British government to issue more index-linked bonds to insulate them from inflation and help cope with worrisome accounting deficits that have intensified since Britain voted in June to leave the European Union.

The UK's Debt Management Office said on Tuesday that its latest consultations with the investors meant it would sell at least one index-linked bond through syndication and two in regular auctions during the third quarter of this year.

Since the Brexit vote, sterling has plunged, leading many analysts to raise their forecasts for inflation. At the same time, the Bank of England has cut interest rates and re-opened its bond-buying programme, causing gilt yields to plummet - exacerbating long-running funding gaps at pension funds.

Ratings firm Fitch on Tuesday warned that the Brexit vote is near-term negative for UK pensions, and that it expects pension deficits to deteriorate further in 2016.

"Pension funds have to hedge inflation risk as around 70-80 percent of the liabilities are inflation-linked: the main means by which you do that is the index-linked gilt market so there's enormous demand," said Jonathan Crowther, head of liability driven investment at AXA Investment Managers.

The Bank of England recently raised its inflation forecasts after sterling's fall, predicting it will reach 2.4 percent in 2018 and 2019 [nL8N1AL2B3.

"Many pension funds are struggling to stabilise their balance sheets – you can see that reflected in the real yields on long-dated inflation-linked gilts. More issuance would certainly provide some relief," said Sorca Kelly-Scholte, head of pensions solutions and advisory EMEA, JP Morgan Asset Management.

The real yield on inflation-linked gilts has fallen across the curve in recent weeks: a November 2065 inflation-linked bond, for example, has dropped 57 basis points to minus 1.67 percent since June 23, according to Thomson Reuters data.

The available stock of inflation-linked bonds is just 396.5 billion pounds, according to the UK's debt management office, compared with 1.1 trillion pounds of conventional gilts.

REVIEW HOPE

"The industry has lobbied successive governments for years to issue more inflation-linked bonds with little success. However, the very stringent (deficit) restrictions put in place by the previous chancellor seem to have been eased," said John Walbaum, head of investment at Hymans Robertson, a consultancy.

Former finance minister George Osborne was aiming for a fiscal surplus by 2020. But after the cabinet posts changed following the EU referendum, the new chancellor, Philip Hammond, said that fiscal policies could be reset if necessary.

The UK's Debt Management Office already has fixed issuance plans for the year, said a spokesman.

"But the plan can get revised at the Autumn statement and we do have some flexibility within the remit to respond to high quality demand for a particular instrument," the DMO official said, referring to the statement made by the UK finance minister every year to update parliament on taxation and spending plans.

ONGOING ISSUE

Pension schemes have been grappling with a mismatch between assets and liabilities for several years now.

Hymans Roberston said the combined deficit of UK Defined Benefit schemes - the difference between the cost of insuring liabilities and the value of the pension scheme assets - has hit 1 trillion pounds. This is a huge increase from the 885 billion pounds at the start of August.

"While this imbalance exists, it remains expensive for schemes to hedge to protect against higher inflation, and there are risks of similar situations such as BHS and Tata if another company goes insolvent," said Walbaum.

British high street retailer BHS went insolvent earlier this year. The firm's pension scheme, which has 20,000 members and a deficit of 571 million pounds, was unable to meet obligations and had to be taken on by Pension Protection Fund, a "lifeboat" scheme paid for by a compulsory annual levy on all British pension schemes.

(Reporting by Abhinav Ramnarayan, editing by Larry King)