The hidden risk in inflation-linked bonds

Such bonds, known as index-linked gilts (ILGs), provide a coupon which is uprated every year by the rate of RPI. The price of this product also increases, and so theoretically investors in the bond should see the capital value of their holding increase by the rate of inflation every year.

However, it is not that simple. Quantitative easing – where the Bank of England (BoE) bought UK government bonds - and demand from pension funds, which require ILGs to match their liabilities, has seen the price of ILGs rise so much that the inflation-driven capital value increase no longer outpaces inflation itself.

For example, over one year, compounded RPI has risen 2.4 per cent, while the consumer prices index (CPI) has gone up 1.6 per cent. In comparison, the FTSE Actuaries UK Index-Linked All Stocks index has only risen 1 per cent.

ILGs are essentially an insurance against inflation. But there are two things investors need to consider. First, insurance is expensive, and it is even more expensive after you realise you need it. Second, sometimes the cost of insurance outweighs the benefits. Currently, the ILG market is showing an extreme example of the cost of insurance. But there are situations where it can be fairly priced and worthwhile buying, but these require an unusual set of circumstances.

“There is a lot of misunderstanding about how they work, what returns they offer, when they do well and when they do badly," says Richard Carter, head of fixed-interest research at wealth manager Quilter Cheviot.

Ben Seager-Scott, chief investment strategist at wealth manager Tilney, says ILGs have a place in portfolios, but only if investors fully understand how they work.

“A lot of people forget that just because they’re inflation-linked doesn’t mean they can’t be cheap or expensive. When investing in index-linked bonds you need to give much greater consideration to real yields, which is the yield minus inflation, which can make them more complex to think about,” he says.

“The key point is: if the BoE starts hiking rates more aggressively than people are expecting, both normal government bonds and ILGs will suffer. Index-linked bonds generally do better when market inflation expectations turn out to be too low, and vice versa,” Mr Seager-Scott adds.

When do they work?

Mr Carter says there are environments that are ideal for ILGs, but these can be few and far between. One situation is when inflation forecasts rise unexpectedly but are not expected to lead to higher interest rates. Higher interest rates can result in a fall in the capital value of bonds, regardless of their inflation-matching qualities.

“Really, the perfect environment was the second half of 2016 – ILGs gave amazing returns then,” he says. “You had a collapsed currency and a jump in inflation expectations, and the BoE was cutting interest rates not raising them. Do we think we’re going into that environment now? It’s unlikely.”

The 12 months after the June 2016 EU referendum, which sparked the depreciation in sterling and the rise in inflation expectations, saw stellar returns for ILGs. RPI was up 3.7 per cent, but the All Stocks index rose 21 per cent. Investors who held longer duration ILGs, ie those with more than 25 years until they matured, could have made gains of 32 per cent.

Given the current market, where the real yield on ILGs is zero, technically ILGs offer very poor value. However, if you strip out quantitative easing and the sharp sterling devaluation to provide a better idea of what ILGs should do within a portfolio, returns do outpace inflation over the longer term. 

There is a case for holding them as part of a portfolio, according to Mike Neumann, head of investment management at EQ Investors, a wealth firm. He says the value of ILGs in a portfolio depends on the expected rates of return from other asset classes (mainly equities), and the expected rate of inflation.

If there is low inflation or deflation, equities would be likely to provide worse returns than ILGs, and normal government bonds would be likely to do well, and ILGs may benefit from this. However, swap this for a more ‘normal’ environment of 3 per cent inflation, and ILGs may be better than cash but not as good as equities, which would also outpace inflation. If this transcended into higher inflation, equities might then struggle, but ILGs would be in their element, also outpacing inflation, as long as interest rates were not rapidly increasing. What is key specifically to the last scenario is having an allocation to ILGs before the time arrives - buying the protection before the need.

Mr Neumann adds: “In practice, markets are never as clear cut as one scenario followed by another. It’s almost always a mix of different scenarios occurring in unexpected sequences, hence the case for a diversified portfolio to include inflation protection whether that be an inflation-linked bond or something similar.”

The duration conundrum

There is another aspect to consider with UK index-linked government bonds. The market for ILGs was created mainly to satisfy pension funds and insurance companies as the bonds pay out regular income, which rises in line with inflation, therefore perfectly matching their liabilities – mainly income payments to pensioners.

However, these liabilities are also very long term, so as such the bonds are also very long term in nature. The bonds carry a very high duration, which on a basic level means the average length of time until the bond matures – and the measure of how sensitive a bond is to rises in the interest rate. The longer a bond has until it matures, and therefore the higher duration, the more its capital value will fall when interest rates are raised by the central bank. As a rule, every 1 percentage point rise in the interest rate will knock off 1 per cent of capital value from a bond for every year of duration.

This is because when interest rates rise, bonds become less attractive relative to cash. The longer a bond has until maturity, the greater risk it carries, and so investors demand a higher yield, and lower price, for a bond before being willing to take that risk.

Therefore, it is important to account for the fact that ILGs have a high duration, especially when compared with normal UK government bonds. For example, the FTSE Actuaries UK Index-Linked All Stocks index has an average duration of 23 years, while the FTSE Actuaries UK Conventional Gilts All Stocks has a duration of nine years.

“If inflation in the UK rises, the income from the ILG will increase, but it is totally secondary to the fact that if interest rates rise at the same time, a 1 per cent rise in rates could result in a 23 per cent fall in the capital value of the bonds. You would get a 1 per cent higher yield, but you probably wouldn’t feel very happy about that,” says Rory McPherson, chief investment strategist at Psigma Investment Management.

In an ideal world, investors would buy into shorter-dated ILGs – those bonds closest to maturity, as these are less sensitive to interest rate rises and less prone to capital losses. However, unless you can circumvent funds and buy bonds directly, these are difficult to come across. Even actively managed UK index-linked bond funds that can cut duration exposure can only do this to a limited extent.

Global inflation

One way to retain inflation linkages while not increasing risk is to buy inflation-linked government bonds from abroad. These bonds would be linked to another economy’s inflation rate rather than the UK’s, but they can still provide a hedge. Global index-linked bonds tend to offer better value in terms of yield and duration than the ILG market. 

Mr McPherson and Mr Seager-Scott have both bought into US index-linked government bonds, known as Treasury inflation-protected securities (Tips), for their clients. 

“We do not think there are inflationary pressures in the UK. A sustainable pick-up needs to be driven by wages, so we focus on the US and the short-dated space, using both active and passive funds,” says Mr McPherson.

Mr Seager-Scott adds: “Short-dated US Tips is one of the few markets that is offering a positive real yield at the moment.”

However, there is the currency aspect to consider when doing this. Mr McPherson has fully hedged the US dollar exposure back into sterling to account for this, but this can be expensive. Mr Seager-Scott has taken on the dollar exposure. If currencies are volatile, they can dominate returns above any impact of inflation and interest rates.

Funds for index-linked exposure

The UK ILG market is difficult to outperform for active managers and given the state of valuations and scepticism over the ability of managers to beat the index, many products have been wound down. Active managers are able to keep duration below the 23 years in the index, so this may be worth considering, but generally their ability to do so is limited. We recommend only passive options.

The L&G All Stocks Index Linked Gilt Index Trust (GB00BG0QNX34) follows the FTSE Actuaries UK Index-Linked All Stocks index, and is one of the most popular options in this space, recommend by numerous wealth managers. Its tracking error shows a good ability to maintain performance with the index, run by the firm’s index team, which has run the fund for almost 15 years. It has an ongoing charge of 0.1 per cent.

The iShares £ Index-Linked Gilts UCITS ETF (INXG) is an exchange-traded fund (ETF) that tracks the Bloomberg Barclays UK Government Inflation-Linked Bond index. The differences between the Bloomberg and FTSE indices are negligible, and this ETF is the largest and most tradable ETF in this space. It has an ongoing charge of 0.25 per cent.

For more international exposure, L&G Global Inflation Linked Bond Index Fund (GB00BBHXNM10) is a passive option tracking the Barclays World Government ex UK Inflation Linked Bond index, with over 60 per cent invested in US government debt and some 30 per cent in European bonds. The fund has an ongoing charge of 0.27 per cent. The fund can be hedged into sterling to mitigate currency risk.

The Fidelity Global Inflation Linked Bond Fund (LU0393653919) is an actively managed fund, but is referenced to the Barclays World Government Inflation Linked 1-10 Years index, meaning it is relatively low duration. The fund is not wedded to government bonds and can invest outside this, but currently has 97.5 per cent allocated to the space. Half the fund is invested in US debt, with about 19 per cent in the UK – but still short duration. The fund has an ongoing charge of 0.51 per cent and is hedged into sterling to mitigate currency risk.

Fund performance

Source: FE Analytics, as at 17.09.2018