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The hidden risk in inflation-linked bonds

Buyers of inflation-linked bonds need to understand their complexities
The hidden risk in inflation-linked bonds

Inflation-beating returns is the minimum objective for most, if not all, investors. Price rises erode the buying power of capital and income, meaning investors must find assets to provide returns that will, at the very least, keep up. But achieving inflation-beating performance can be a complicated task. A common perception is that UK inflation, as measured by the retail prices index (RPI), can be mitigated by investing in UK government inflation-linked bonds. However, this is a very common misconception.

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.

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