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By Ana Nicolaci da Costa

LONDON (Reuters) - Pension funds are still keen to buy inflation-linked British government bonds, despite slower price growth, but the country's debt agency head said he would be careful about agreeing to any increase in auction sizes.

Investors have said they want more debt to be sold at index-linked auctions, even as British inflation falls below the Bank of England's target.

Robert Stheeman, the head of Britain's Debt Management Office, told Reuters on Tuesday there was sustained demand from the pension fund industry, including the life insurance sector, and linkers had become an "asset class in their own right" and part of well-diversified portfolios.

"It's a message we have listened to very carefully but we need to think about the strength of the market, the liquidity of the market," Stheeman said on the sidelines of a conference in London.

"There is always a danger that if we issue too large (a) size relative to the underlying liquidity, the market might find it somewhat more difficult to absorb that risk and you might see more volatility around the issuance process."

Britain's economy staged a faster-than-expected recovery last year but a combination of lower commodity prices and a strengthening of the pound has helped cap price increases.

Consumer prices rose 1.9 percent on the year in January, slowing from December's rate of 2.0 percent and falling below the BoE's target for the first time in over four years.

Britain's budget for the 2014-2015 fiscal year is due to be released on March 19 and Stheeman declined to give specific details about the debt agency's issuance plans.

But he said that, in general, bonds linked to consumer price inflation (CPI) could not be ruled out in the future. Inflation-linked bonds are currently linked to the typically higher rate of retail price inflation.

"There are reasons for us to issue CPI (linked bonds). I am not saying that there is no demand (for CPI-linked bonds), there is demand, but we have to try to make an assessment (about) how large that demand is and whether that demand is sufficient to be deemed cost-effective ultimately to the taxpayer - that's the key point for us," Stheeman said.


Last week, Britain's government granted Scotland the power to raise some debt in its own name as the country gears up for a vote on independence in September.

Asked whether Scotland had been in touch with the debt agency about issuing its own bonds, Stheeman said: "No, it's entirely for them to decide if they want to do that or not."

He added: "The Scottish government would have to be comfortable with any premium that they might have to pay, but I have no idea what that precise premium would be, at this early stage I don't think anyone does."

However, Stheeman said the issuance of Scottish bonds would have minimal impact on the gilts market.

Scotland is only allowed to issue up to 2.2 billion pounds of sterling-denominated bonds, according to the announcement last week, and this compares with the 153.7 billion pounds of gilts the DMO will issue on behalf of the UK government in 2013/14, Stheeman said.

"The amounts involved in relation to what we are currently borrowing and in relation to the liquidity of the gilt market are such that it would have, in my opinion, virtually no impact on the gilt market," he said.

The index-linked gilt market was 360.4 billion pounds at the end of 2013. The size of the gilt market was around 1.4 trillion pounds in February. ($1 = 0.5994 British pounds)

(Reporting by Ana Nicolaci da Costa; Editing by Ruth Pitchford)