Many of you are worried about the possibility of rising inflation, which raises the question: should you buy index-linked gilts as protection against this danger? In fact, it’s not at all obvious that you should.
Yes, they protect us from inflation because both the redemption value of the bonds and their income are raised in line with inflation. But such protection comes at a high price. The real yield to maturity on 10-year linkers is now minus 2.6 per cent. Which means that if you hold them to maturity you will lose 23 per cent of your money after inflation over the lifetime of the bond.
There’s worse. If you don’t hold the gilt to maturity or if you hold linkers through funds, you risk a capital loss because yields could rise as inflation rises.
What matters here is why inflation rises.
Imagine it were to do so because an economic boom raised demand and prices. In this scenario, linkers’ prices would probably fall as investors shifted away from them and towards equities because of higher earnings expectations and increased appetite for risk.
If, on the other hand, inflation were to rise because it becomes more expensive or difficult to produce goods and services then linkers would do well, because we would get inflation without extra economic growth. After the vote to leave the EU in 2016, for example, inflation expectations and index-linked gilt prices both rose because markets expected trade barriers to increase costs of production and prices while reducing real economic growth. Those are the sort of conditions that favour linkers.
What also matters is whether the inflation is home grown or global. If we get purely domestic inflation then nominal gilt yields won’t increase much. This is because government bonds in western economies are close substitutes for each other and so nominal yields are held in place by overseas yields. In this event, any rise in break-even inflation (the difference between conventional and index-linked yields) would reduce index-linked yields: this is a simple mathematical fact. Which means capital gains on them. This too is what happened after the vote to leave the EU.
If, on the other hand, inflation is global things will be very different. Nominal yields would be dragged up by rising yields overseas, but break-even inflation won’t necessarily rise much if at all except to the extent that investors expect the UK to import inflation. In this scenario, linkers’ yields might well rise – meaning capital losses. For this reason, if you fear that President Biden’s fiscal stimulus will raise US inflation, you probably should not be holding linkers as protection.
Something else also matters – whether the Bank of England allows higher inflation or not.
If it tries to clamp down on incipient inflation pressures it would raise not only nominal interest rates but real ones. This is because reducing inflation requires the Bank to reduce demand and it can only do this by raising interest rates by more than prices. Index-linked yields, though, are equal to the expected path of short-term real interest rates. And this means that yields would rise in this event, again imposing capital losses.
If, on the other hand, the Bank were to tolerate higher inflation, investors would anticipate lower real interest rates and so index-linked gilts would do well.
Which raises an uncertainty. The Bank says it will not raise rates until there is “clear evidence” of it achieving its 2 per cent inflation target “sustainably”. This implies that it will accommodate some inflation – some this year caused by the mathematical effect of last year’s low oil prices falling out of the annual data in the spring, and some as it waits to see that the post-pandemic economic recovery really has raised inflation for good.
The more inflation the Bank accepts, the better for linkers.
In theory, then, linkers are not necessarily protection against inflation. It all depends what sort of inflation we get and how the Bank responds.
All of which fits two big facts.
Fact one is that there is no significant correlation between inflation expectations (as measured by the five-year break-even inflation rate) and the five-year index-linked yield. Since 1985 the correlation between annual changes in the two has been minus 0.1. This means that although linkers prices are slightly more likely to rise than fall when inflation fears increase, the odds of them doing do aren’t much better than 50:50. Which means there’s a high chance of holders of linkers not getting the inflation protection they expect.
Fact two is that linkers have done well during a time of low and stable inflation. In the last 20 years they’ve delivered a real return of 5 per cent a year while CPI inflation has averaged only a little more than 2 per cent. This tells us that something other than inflation has raised returns on linkers. These somethings are long-term economic stagnation, shortage of safe assets and a global savings glut, all of which have driven down real yields. But, of course, if linkers can do well when inflation is low they might do badly when it is high.
Which poses the question: if linkers don’t protect us from inflation, what does?
Not gold. Its price tends to fall when bond yields rise. Nor equities. Sure, these would benefit from the boom in demand that raises inflation expectations, but they’d suffer if investors fear rising interest rates.
And this is why inflation is so nasty for investors. Serious inflation might, in my opinion, be only a low probability. But it’s nasty if the risk does materialise.
