The swaps are structured so that the amounts received by the scheme do not reduce with deflation, while there is no limit on their increase.
The swaps increase the total amount of inflation linked assets in Boots' 100% fixed income £2.4bn fund to approximately one third, up from the one quarter already allocated to index linked bonds.
The scheme's holdings include the World Bank's 2030 £100m public bond issued in August 2000, of which Boots was the sole purchaser. The deal, led by RBS, was the first supranational index-linked sterling deal. By the end of 2000, the fund had bought a large proportion of the total index linked sterling issuance from supras.
John Ralfe, head of corporate finance at Boots and member of the pension investment committee, explained that following the buying spree it had become difficult to find any more index linked payers. "Barclays and Natwest [now Royal Bank of Scotland] had a standing order to winkle out more from a very illiquid market. These latest inflation linked swaps have the advantage of protecting against deflation, whereby the amount we receive does not go down. We have had to pay a slightly higher rate for the floor on the swap, but it is not much in the long run."
Although the Boots swap suggests the makings of an inflation linked corporate bond market and derivatives market, most buyers of sterling inflation linked products will have to rely on UK government issuance of index-linked Gilts, which is being increased to £4.5bn in the fiscal year ending April 2003. There are already £75bn of index-linked Gilts in circulation and no redemptions coming up, so issuance is rising.
Mark Capleton, head of inflation linked research at Barclays Capital, explained the rationale behind such products: "The reason why people save is to defer future consumption, so you are only interested in the real value of your savings. Instinctively, you should regard inflation-linked investments as the lowest risk assets, giving you a greater degree of certainty of their purchasing power."
But there are more pragmatic reasons, he added. "Under the UK's 1995 Pensions Act, companies have an obligation to increase their pension liabilities in line with the Limited Price Indexation, which is effectively the retail price index with an annual cap and collar between zero and 5%. So the obligation to escalate pension benefits has both a nominal part and a real part. Given the scarcity of LPI bonds, the lowest risk way to match that obligation is probably to hold a mixture of nominal bonds and index-linked bonds."
The official UK inflation target is 2.5%. However, the 30 year break even inflation, which is the difference between the 30 year Gilt and the 30 year index-linked Gilt, suggests inflation running at 2.8%. "The difference probably reflects scarcity of supply," said Capleton.