Why investors buy index-linked gilts

In theory, linkers should have a lot going for them. In the UK, index-linked gilts adjust the nominal coupon payment and final settlement in line with inflation, meaning they retain their real (inflation-adjusted) value. At a time when inflation is still nudging 8 per cent, this all looks very attractive. 

Last week, Bank of America (BoA) rates and currencies analysts even characterised inflation-linked bonds as a true risk-free asset. After all, if you save for future consumption “your prime concern – perhaps your only concern – should be what you’ll be able to buy with your savings in the future”. The implication is that the potential for capital losses – as seen last year for longer-dated inflation-linked debt – shouldn't matter so much.

The BoA analysts also added that index-linked gilts have the added benefit of allowing investors the “opportunity to express views about future inflation and real policy rates explicitly”. This is because when deciding whether or not to invest in inflation-linked bonds, investors need to take into account their own expectations for how inflation will evolve, and how this stacks up relative to what the bond market anticipates. 

Take a stylised example of a five-year nominal bond yielding 4 per cent between now and its maturity. An investor buying this bond would get a real return of 4 per cent, minus whatever realised inflation turns out to be over the five-year period. But in place of this nominal bond, an investor could buy an index-linked bond of the same maturity instead. It yields a lower 0.5 per cent between now and its maturity – but, crucially, this will be inflation-adjusted.

Now comes the interesting part. If the investor thinks that inflation will be higher than 3.5 per cent over the period, they anticipate that the real return on the nominal bond will be whittled away to less than 0.5 per cent thanks to the corrosive effect of inflation. In this case, they would be better off with the index-linked bond. If, on the other hand, they expect realised inflation below 3.5 per cent over the period, they anticipate a higher real return from sticking with the nominal bond. Economists call the difference between nominal and real yields the ‘breakeven inflation rate’: the differential at which expected returns of linkers and nominal bonds are equal. 

At the time of writing, the five-year inflation breakeven implies that retail price index (RPI) inflation will average 3.7 per cent over the period. This is (historically) equivalent to about 3 per cent by the more commonly used consumer price index (CPI) measure. With UK CPI inflation still at 7.9 per cent, this might sound optimistic to some, and a gross underestimate to others. After all, predicting the future path of inflation has proved difficult – almost impossibly so. As the chart below shows, even forecasters at the Bank of England (BoE) have been forced to readjust their inflation expectations dramatically over the past 18 months. 

Juan Valenzuela, co-manager of the Artemis Bond Fund, told Investors’ Chronicle that the breakeven inflation implied today is “arguably too high given how aggressive the BoE has been”. Nevertheless, he added that “with base rates in the UK above 5 per cent, the likelihood of inflation realising anywhere near the levels experienced in the past 18 months is low, but the outlook for inflation remains one of uncertainty and elevated inflation volatility.” 

This isn’t all that investors need to take into account. Valenzuela points out that “UK linkers are bonds and bonds do not like inflation”. He added that “ultimately the destiny for UK linkers is the same as for conventional gilts”: nine times out of 10 they both move in the same direction. And so last year, when inflation was soaring, linkers suffered significant capital losses.

There are also macroeconomic policy changes to contend with. As the impact of higher interest rates starts to feed through to the economy, UK policymakers could find themselves wrestling both a sluggish economy and above-target inflation, resulting in a nasty stagflationary mix. In this climate, a decision to cut interest rates would not be straightforward: according to Valenzuela, central banks risk the perception that they are “compromising” their inflation targets. 

Though bad for policymakers, this could be good news for shorter-dated index-linked gilts if interest rate expectations moderate, and breakevens widen as inflation expectations rise. According to Valenzuela, in this case, “inflation-linked bonds in the shorter end of the curve will be a compelling asset to own”. But uncertainty reigns. Predicting inflation is one thing, anticipating the BoE’s next move is quite another.