Views from the LDI desk – December 2024

CPI – Back to basis

Estimated reading time: 7 minutes

The UK CPI inflation print for October 2024 came in at 2.3%, beating expectations from many economists as energy prices had a bigger impact than expected and both services and core goods exceeded Bank of England (BoE) forecasts.

Importantly for many Corporate DB pension schemes, RPI inflation also ticked higher, printing at 3.4% while CPIH, which includes owner occupied housing costs, continued to exhibit a large uplift to CPI at 3.2%.

With RPI reform slowly coming onto the horizon in 2030, where RPI will be rebased to equate to CPIH, the basis between CPIH and CPI will become increasingly important for schemes, especially those that believe themselves to be well hedged.

We look at what drives this basis, what’s been happening to it and considerations around taking the plunge with CPI swaps.

RPI Reform Reminder

RPI reform was announced in 2020 after years of consultation and set out plans for the UK Statistics Authority to align the calculation methodology of RPI with CPIH from February 2030. The so-called ‘wedge’ between RPI and CPI has been volatile over the years, with differences in weights and constituents (particularly Mortgage Interest Payments, or ‘MIPS’) driving much of this, but a range of other formulaic differences also often driving disparity, something which has at times come in for historical criticism.

As the charts below show, RPI has printed around 0.8-0.9% higher than CPI, on average, over the long run with much of this in-built upward bias driven by formula effects, interspersed with periods of more extreme basis moves caused by MIPS, for example post the 2008/2009 financial crisis where interest rates were cut sharply.

RPI historically printed above CPI with periods of volatility in this basis

CPI and CPIH have tended to track more closely, with the average basis between now and 1989 at just 5bps, reflecting the aligned formulae used in the two measures. However, more recently we have seen more extreme moves in this basis. That has primarily been a function of the basket weights and constitution of the two indices.

CPI and CPIH have tended to track quite closely until recently

Rents on the rise

The differential between CPI and CPIH is the inclusion of an Owner-Occupied Housing (OOH) component in CPIH. This inclusion of OOH costs skews the weight to the housing category (04) upwards by almost 17%, with commensurate reduction in other categories making up for this differential. These weight differences are an important source of volatility in the basis.

The OOH measure is calculated on the basis of rental equivalence, with values imputed from the rents paid for equivalent rented properties. Therefore, changes in rent levels really matter to the CPIH.

Inclusion of OOH drives a wider range of weight differences

And rents have been rising - sharply. As the ONS reported in November 2024, rents up to October increased by 8.7% year on year, with the post-COVID trend of a move back to cities increasing demand, while continued regulatory and tax changes on landlords have driven a longer term reduction in the supply of rental properties, particularly in locations such as London.

Strong rental growth is driving a high contribution from OOH costs in CPIH, causing CPIH to print well above CPI over the past few months and a far cry from the average basis of 5bps observed over the long term.

Conversely, during much of 2021/2022, CPI printed significantly above CPIH, despite rental growth already being strong. This reflects the relative inflation levels on other components of the basket across goods and services, to which CPI had a higher weight than CPIH, exceeding the inflation levels seen in OOH costs. While the two indices have significant overlap, the impacts of OOH and weight differences can be significant during volatile periods.

Both OOH strength and weight differences have driven CPI/CPIH basis in the past few years

How does the market price reform and CPI vs. CPIH?

CPI curves are available daily from pricing vendors, so one can compare CPI and RPI pricing. However, the 2030 start date of RPI reform confuses matters, with pricing up to that point reflecting the RPI/CPI wedge and pricing beyond this point reflecting a blend of RPI/CPI and CPI/CPIH.

RPI and CPI swap pricing converges as the effect of the pre 2030 wedge drops out

Considering inflation swap pricing on a forward starting basis allows these effects to be disaggregated, showing how post 2030 the basis starts to reflect the CPI vs. CPIH basis, with a range more between 0bps and 20bps.

Considering forward-starting difference between 1y RPI and CPI swaps presents a clearer picture

Compared to the longer-term historic ranges on the basis, these levels do not look unreasonable albeit perhaps still 10bps expensive vs. the long-term average of CPI/CPIH. Arguments could be made that with recent strong growth in OOH this premium might be justified if one believes there are more structural supply and demand factors that may persist, leading to OOH increasing at a faster rate than the rest of the CPI basket. Schemes with CPI linkage in their liabilities might ask whether they should be hedging this basis risk in the long term?

Pre and post reform forward spreads have been converging around long term averages

How easy is it to trade CPI swaps and what are the risks?

CPI swaps are traded bi-laterally and not currently supported for central clearing. While, in theory, it is possible to trade CPI upon request, the reality of the market is that liquidity tends to cluster around supply events, with banks predominantly sourcing CPI exposure on the back of deals linked to renewable power contracts or from the hedging of other utility and infrastructure linkages.

But what are the potential downsides of executing CPI swaps to hedge any RPI/CPI basis or subsequently CPI/CPIH basis risks that schemes may face due to linkages in the liabilities to the statutory minimum uplift of CPI? There are several, and in our view, they do merit serious cause for thought:

• Lower Liquidity – liquidity in CPI swaps is meaningfully lower than in index-linked gilts or even bi-lateral RPI swaps. This means care is required when entering positions, but also that future re-balancing may be challenging, particularly if CPI linked liabilities are subject to caps and floors. If a scheme subsequently chooses to pursue an insurance transaction, there is no guarantee the insurer will want to take the positions on. The status and appetite of bank counterparties to hold positions can also change over time. Lower liquidity instruments can also add additional complexity in transparency and valuation as there is less readily available data.
• Manages one basis risk but may introduce others – while the whole reason for trading a CPI swap is to manage potential basis risks vs. RPI or CPIH linked alternatives, the use of a swap introduces its own basis risks where schemes value liabilities based on gilts.
• May reduce capital efficiency – switching hedging from RPI (or CPIH post 2030) to CPI may also mean switching existing index-linked gilts into conventional gilts and a swap, which can have implications on capital efficiency and repo usage given the typically lower duration of conventional gilts. In a fully funded scheme that needs limited leverage, the use of swaps would re-introduce counterparty risks and the need to manage collateral. If used alongside corporate bonds to overlay inflation exposure as part of a CDI strategy this could be less problematic as swaps will likely be used anyway.
• Future regulatory risk – It is possible that in the future there are legislative changes that restate the statutory minimum uplift from CPI to CPIH. While there is not active discussion around this change at present and we have no reason to suspect it to occur imminently, such a change would render CPI swaps held less useful and likely further reduce their liquidity.

Pension scheme trustees and their advisors need to consider whether they are exchanging one basis risk for a series of others and a wider range of potential future headaches when transacting CPI swaps.

Key takeaways for pension schemes

• Planned RPI reform in 2030 will reduce the volatility between typical RPI linked hedging assets and CPI linked liabilities for schemes that have them.
• Whilst the CPIH-CPI basis is lower, as the last couple of years have shown, hedging CPI linked liabilities with CPIH linked assets does not always guarantee a good match and there can be periods of dislocation.
• CPI swaps have grown in liquidity in the past few years and pricing is closer to historical averages and what might be considered fair value, albeit they are likely still exhibiting some premium.
• But CPI swaps come with their own sets of risks and challenges and schemes need to carefully assess based on their circumstances and end game whether they are replacing one risk with a set of others.

The opinions expressed are as of December 2024 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

Risks

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Past performance is not a reliable indicator of current or future results.

Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.

Important information

This material is for distribution to Professional Clients (as defined by the Financial Conduct Authority or MiFID Rules) only and should not be relied upon by any other persons.

Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Tel: + 44 (0)20 7743 3000. Registered in England and Wales No. 02020394. For your protection telephone calls are usually recorded. Please refer to the Financial Conduct Authority website for a list of authorised activities conducted by BlackRock.

Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer.

© 2024 BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, and iSHARES are trademarks of BlackRock, Inc. or its affiliates All other trademarks are those of their respective owners.