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Index-linked gilts as protection

Index-linked gilts don’t necessarily protect us from inflation. In the last six months they have lost 10 per cent as yields have risen; the 10-year yield is up 0.6 percentage points since October to minus 2.3 per cent. Coming at a time when CPI inflation has hit a 30-year high, this loss refutes the notion that linkers are a reliable protection from inflation. It is only if you hold them to maturity that this is the case. Otherwise, they can lose money in times of high inflation.

In truth, this shouldn’t surprise us. The yield on an inflation-linked bond should be equal to the path of expected short-term real interest rates over its lifetime, just as the yield on a conventional bond should be equal to the path of expected nominal short rates. If investors expect central banks to raise real interest rates in response to inflation – as they should if monetary policy is to tighten – then inflation will raise real yields, causing a capital loss. Which is what we’ve seen.

So far, so straightforward. But this poses the question: if linkers don’t always protect us from inflation, when do they prosper? It’s a trickier question than you might think.

Yes, sometimes they do well when equities do badly, for the same reason that conventional bonds do well; they are seen as a safe haven in times of high risk. Linkers did well during the tech crash of 2001-02 and the euro crisis of 2011, for example.

But they don’t always do well when equities sell off. In late 2008 and at the start of the pandemic in 2020 they lost money. This is because when investors fear deflation – falling consumer prices – they switch out of linkers and into conventional gilts.

Nor do linkers necessarily do well when oil prices rise. You might expect them to because higher oil prices raise inflation and threaten to squeeze the profits of non-oil companies. With one being bad for conventional bonds and the other bad for equities, linkers should therefore benefit. But in fact the combination we’ve seen in the last few months of rising oil prices and losses on linkers is not so unusual. Higher oil prices can be a sign of a stronger global economy and therefore bad for linkers as investors cut their demand for safer assets: we saw this, for example, in 2017-18 and in 2020-21.

A more robust relationship is the tendency for linkers to do well when sterling falls, as we saw in 2012-13 and after the vote to leave the EU in 2016. This isn’t just because a weaker pound can raise inflation. It’s also because it can be a sign of lower appetite for risk, which benefits safer assets such as linkers.

But again, not every fall in sterling benefits linkers. In fact, these would do badly if the Bank of England responds to a weaker pound by raising real interest rates. Since 1999 the correlation between six-month changes in sterling’s trade-weighted index and six-month returns on linkers has been minus 0.24. That means there’s a tendency for linkers to do well when sterling falls – but only that: a tendency, not a reliable relationship.

Index-linked gilts, then, are not strongly correlated with macroeconomic fluctuations, be it inflation, economic growth, exchange rates or commodity prices.

There is, however, one big fact about them. It is that until recently, they have delivered great long-term returns. From December 1999 to December 2021 they gave a total return of 7.1 per cent a year – 2.2 percentage points more than the All-Share index.

This of course is just another way of saying that real yields have been trending down for decades: ten-year ones were over 4 per cent in the early 1990s but are less than minus 2 per cent now.

Herein, however, lies a threat to linkers. One reason for this downtrend has been what MIT’s Ricardo Caballero calls a shortage of safe assets. Investors, especially in Asia and the Middle East, have wanted a safe home for their money but haven’t trusted their own banking or political systems or stock markets, and so have bought western bonds in the belief these were safe.

Which they were until recently. Western sanctions against Russia, however, have posed the question to wealthy people and organisations everywhere: if Russians’ assets in the west can be seized or frozen, why can’t those of other nationalities if the political winds change? Fearing this, Asian and Middle Eastern investors have less reason to trust the safety of western bonds. Which is one reason why they have sold off so much since Russia invaded Ukraine.

One factor behind falling real yields, then, has weakened – perhaps for good.

But only one. Other causes of low yields are still with us, not least of which is low economic growth around the world. The case for holding linkers is not so much that they protect us against short-term risks such as falling share prices or rising inflation, but that they protect us somewhat against the longer-term danger that western economies will continue to stagnate and so real interest rates will stay low.