Index-linked bonds: A lifeboat from inflation's rising tide?

Will Railton
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Inflation-linked gilt prices have risen sharply since the second half of 2016, after the Bank of England cut interest rates to a record low of 0.25 per cent (Source: Getty)

Inflation should be a concern for investors as well as consumers. The Bank of England anticipates that price rises will accelerate this year and peak at 2.8 per cent in early 2018.

These predictions may not play out, but unless you’ve invested in assets whose value will increase by at least as much as the rate of actual inflation, your money won’t go as far in future as it does at the moment.

Read more: This economic environment won't last: Should you pay down your mortgage?

With the interest offered by cash Isas and easy access savings accounts already far less than today’s inflation rate, which assets can offer you protection?

Index-linked bonds, which are issued by governments and some companies, seem to be an obvious solution. Known as “linkers” in the UK, the coupons and principal value of inflation-linked bonds adjust automatically with a recognised measure of inflation, such as RPI.

“They typically pay investors a real yield plus accrued inflation which, in theory at least, should mean that investors are inflation-hedged,” explains Ana Gil, investment specialist in the M&G retail fixed interest team. Retail investors can get easy exposure through exchange-traded funds (ETFs), such as the iShares Index-linked Gilts UCITS ETF which tracks the Bloomberg Barclays UK Government Inflation-Linked Bond index.

Job done? Not exactly. As expectations of rising inflation have been well signposted, the price of these bonds has already adjusted upwards to reflect that. Index-linked bonds are only attractive when actual inflation rises faster than expectations, when the yield on a nominal bond of the same maturity is low and would generate a lower return. In other words, an index-linked bond investor would need the actual rate of inflation to be higher than the difference in the yield between an inflation-linked and nominal bond.

Inflation-linked gilt prices have risen sharply since the second half of 2016, after the Bank of England cut interest rates to a record low of 0.25 per cent, and much of the anticipated uplift in inflation from the recent rise in oil prices has already been priced in. In February, the Treasury issued a 50-year inflation-linked bond with a record low inflation-adjusted return.

“We’re more positive about US inflation-linked bonds than UK ones,” says Justin Onuekwusi, multi-asset fund manager at Legal & General Investment Management, who points to the different drivers of inflation across the Atlantic. “The US is beginning to move to the latter stages of the economic cycle.

In addition to the oil price rise, the labour market is tightening, wage pressures are increasing, and we are entering a new political paradigm. Higher tariffs on imports would be inflationary, particularly in the short term, and with Trump aiming at 4 per cent growth there’s a real chance of the economy overheating,” he says.

Unlike index-linked gilts, the accrued principal on Treasury Inflation Protected Securities (TIPS) cannot fall below their initial par value, minimising the threat of a slide towards deflation.

There are a number of other risks to investing in passive inflation-linked bond funds. Market demand is dictated chiefly by pension funds and other institutional investors looking for safe assets, and which prefer notes with very long durations. This is particularly true of the UK, which has long been a haven for fixed income investors, leaving ETFs which track the market vulnerable to “duration risk”, or the risk that the Bank of England will raise interest rates, even slightly, over a period of decades.

This article appears in the latest edition of City AM's Money Magazine, released with the paper today.

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