Bank of England, 1995, Overview Papers, Bank of England Conference: The U.K. Index-Linked Gilt-Edged Market: Future Developments (London: September).
Bankers Trust Australia Limited, 1993, “Inflation-Indexed Securities: Analysing the U.K. Index-Linked Gilt Market - Comparisons for Australia”1, [July].
Bodie, Zvi, Inflation, 1988, “Index-Linked Bonds, and Asset Allocation”, (National Bureau of Economic Research Working Paper No. 2793, December).
Bodie, Zvi, Inflation, 1990, “Inflation, Index-Linked Bonds and Asset Allocation: The Gains to Investors from Index-Linked Bonds”, The Journal of Portfolio Management, [Winter], pp. 48–53.
Deacon, Mark and Andrew Deny, 1994a, “Deriving Estimates of Inflation Expectations from the Prices of U.K. Government Bonds”, Bank of England Working Paper No. 23.
Fischer, Stanley,, “On the Nonexistence of Privately Issued Index Bonds in the U.S. Capital Market”, Chapter 10 of Indexing, Inflation and Economic Policy.
Hetzel, Robert L., 1992, “Indexed Bonds as an Aid to Monetary Policy”, Federal Reserve Bank of Richmond Economic Review, [January/February], pp. 13–23.
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Prepared by David J. Ordoobadi.
A primary dealer system was introduced in 1986 featuring gilt edged market makers (GEMMs) obligated to make continuous and effective markets in the whole range of gilt stocks. In return, GEMMs were accorded the right to deal directly with the BoE, given access to inter-dealer broker facilities, and permitted to borrow stock to establish short positions. Issuing procedures were also changed. Auctions became the main method of issuance, but there was no regular auction calender. Nevertheless tap issues continued to represent a significant share of new issues as the BoE retained the option of opening additional “tranchettes” of previously issued stocks at short notice in response to market conditions.
The United States Treasury has recently announced that a 10-year bond indexed to the CPI would be issued in early 1997.
Innovations under the 1996-97 remit include monthly auctions, the auctioning of two different stocks in the same week to facilitate risk spreading by GEMMs, and permitting GEMMs to bid non-competitively for limited amounts of stock as a means of reducing their risk of being unable to cover client orders.
Auctions for IGs will be considered once that market becomes sufficiently developed.
The growth of the repo market contributed to strong increases in broad money in January, although its impact on the monetary aggregates waned thereafter.
The funding cost of gilt portfolios declined from LIBOR to LIB ID, minus a margin. At the same time, securities lending fees have declined from 25 basis points to 10 basis points.
In order to reduce the impact of the variability of the collateral’s market price on credit risk, a security underlying a repo is typically valued at its market price (including accrued interest) less a margin or “haircut” determined as a function the credit quality of the counterparty and the issuer, the term of the repo and the variability of the price of the underlying security.
Previously, gilt interest income was taxed when paid, while capital gains and losses were untaxed and unrelieved.
Real estate and commodity futures have been used by institutional investors as an inflation hedge with mixed results. Real estate suffers from basis risk, even lower liquidity than IGs, cumbersome investment vehicles, and the absence of a discernible market clearing price. Commodity futures can be highly volatile and must be assembled into baskets to provide a reasonable chance of tracking inflation.
In times of high inflation (or high uncertainty), indexed bonds also may help to secure funds that would otherwise not be forthcoming. This feature may be of particular interest to economies with fledgling financial markets experiencing difficulties in mobilizing capital because of investor fears of inflation.
Breedon (1995) estimates that market inflation expectations, as expressed by the spread between conventional and indexed gilts, has exceeded actual inflation by 170 basis points. However, not all of the spread between conventional and indexed gilts represents inflation premia: differential tax treatment and liquidity also affects this spread. Moreover, inflation risk premia appear to be variable with changes in expected inflation.
If the rate of nominal accrual remained uncertain between coupon payments, trading in IGs would be limited to coupon payment dates. Cash flows are not protected from inflation during the period from the establishment of the inflation adjustment and payment. The impact of the lag on the actual inflation protection afforded an investor is inversely related to the bond’s maturity. Similarly, the higher the rate of inflation during the intervening period, the greater the reduction in inflation protection. An investor will benefit if inflation falls during the lag, but lose if it rises.
IG liquidity is also adversely affected by the inability of dealers to hedge their indexed bond positions, with the result that dealers have the incentive to transact mainly on an agency basis. Moreover, not all GEMMs are active in the IG market.
Strictly speaking, the real return on an indexed bond is assured only if held until maturity, as its value in the interim will be affected by changes in real interest rates.
Over a similarly long time horizon, United States equities and long-term bonds have generated average annual returns of about 6 percent and 1 percent, respectively.