Confused between long-dated gilts & index-linked gilts

Ark_Welder

The last thing that I am trying to do is to change your mind in what you are doing, nor in how you are going about what you are doing. Just trying to provide some information and opinion that might be of interest. As you state, what is right for you now might not be in the future, and what is right for me might not be right for anyone else at any time.

I've been investing for 25 years and what is right for me is, on the whole, investing though collective vehicles, i.e. OEICs, UTs and ITs. And on the whole, managed ones. For others, they will make direct investments because they have found that it is right for them. I am a great believer in gathering information - even about assets and strategies that I would not necessarily utilise. Knowledge doesn't lead to as many surprises as a lack of knowledge.

Don't necessarily close yourself off from any particular avenue, but don't change for the sake of it either. You might find, 20 years hence, that what is right for you is still to invest through trackers.


Gilts. Difficult! As has been said by kidmugsy, long-dated conventional gilts can be quite risky on their own, which is mainly interest-rate and inflation-rate risk. These two risks affect short-dated less because of the gilts being closer to their time of redemption and at a known price. However, looking at the DMO list of conventional prices shows that all dated conventional gilts are trading above par, so a purchase of any gilt will lead to a loss of capital. And that is a problem for gilt funds too. If you look at the second and third pages where the index-linked prices are then you will see that some of the real yields available are actually negative, i.e. you will receive back less than the expected rate of inflation at maturity - that is an indication of how overpriced index-linkers are currently. Of course, that could change and they could turn out to be quite cheap!

It is possible to read two different messages from gilts: conventional prices and yields are suggesting lower inflation in the coming years, whereas overpriced linkers are suggesting higher inflation. So for me, right now, I do not have direct holdings of either, nor am I looking for a holding. But I do have exposure through funds, but the funds are not gilt-specific.

If I were in your position, what might I do? If the decision had been made to definately hold gilts (and not something in addition, such as corporate bonds of various hues) then I would look at a managed fund, and for the following reasons:

• Conventional gilts are trading above par, so a capital loss is guaranteed if held to redemption (although you could make a gain if they are sold before then)
• Index-linked are overpriced and so may actually return less than the rate of inflation going forward
• An index tracker fund will do exactly that, track conventional gilt prices down when they do eventually fall, and a fall could be for a variety of reasons
• A managed fund might be able to move between conventional and index-linked as circumstances change - and change they will!

As part of your research I would suggest reading up on the different types of bonds and bond funds that are available, and how each are affected by different economic circumstances. Not necessarily to make an investment in them right now, merely to allow you to take a view on them at some point. There are some that will rise when interest rates rise, and there are those that do better when the economy is doing well, but each of these bring in a different set of risks. And don't necessarily ignore funds that hold overseas bonds either - although these might have a new set of associated risks!

evilplan

Thank you so much, Ark Welder. Indeed it's the very fact that you weren't trying to change my mind that's allowed me to approach your comments with an open mind.

I definitely need to do some more reading; I've been engrossed in the links you gave me for some time now, and there's a lot to try to get my head around.

The one thing I'll definitely say is, I realise it's not the simple decision my original post indicated it was, and it needs a lot of careful thought - I certainly won't be jumping in to anything (although the luxury of having a new, drip-fed portfolio is that there isn't much to jump with!)

I've said elsewhere on here today that the quality and generosity of people in offering their opinions and experience is really quite brilliant, and your posts have really given me a lot to think about - so, once again, thank you for taking to time to explain so much.

pqrdef

evilplan wrote: »

For this approach, he recommends 20% into long-dated gilts.

Well it's a strange approach that picks investments without reference to price. Especially when it recommends trackers. A good manager should aim to be in value whatever the state of the sector, but a tracker has no choice but to be overpriced when the sector is.

And all gilt funds are basically trackers, because gilts all go up and down together.

And there's no upside in overpriced gilts. There isn't going to be a bull run built on optimistic expectations of even higher prices.

And gilts are historically overpriced just now. There we were all amazed at just how cheap the Treasury could borrow, considering the state of the economy, and wondering how long it could last before we joined the PIIGS. And then the Americans and Japanese and Swiss all started playing silly b*ggers, in the way that only politicians can, and the UK suddenly became a safe haven for funk money.

So the questions would be, will gilts be cheaper later, and will they make more than cash in the meantime?

Because equities aren't the only alternative. If gilts are being considered, cash in the bank is also an option on the table.

Does Hale give a reason for preferring gilts to cash, or does he just say to set aside a limited amount of cash and all the rest must be "invested"?

There may be a case to buy gilts as a way to put S&S ISA money into something cash-like. There's a case to buy linkers if you want long-term inflation insurance. There may be a case to buy short-term linkers if you want short-term inflation insurance without locking up your money. And the RPI uplift on linkers is CGT-free. So they do have their niche uses.

pqrdef

evilplan wrote: »

As a general indication, would you say someone is better off saving their £50/month until they can buy some actual gilts, or would you say "any investment in gilts is better than no investment in gilts" (if we assume that I've decided that my strategy should include gilts) and that it's wise to continue to invest in a fund until I have more resources available?

Trading in gilts you'll pay commission and spread and stamp duty, and you'll struggle to cover all that. Same goes for ETFs. The low-cost funds are the only practical option really.

evilplan

"Well it's a strange approach that picks investments without reference to price"

pqrdef - I guess I was talking in shorthand. Hale goes into huge detail about how and why and when and what to invest in, depending upon your strategy and risk appetite. The whole thrust of the book is "have a strategy and stick to it".

So I just extracted his advice re gilts in simple form in order to ask the basic question about why he was calling one "long-dated" and the other "short-dated", and after all the conversation here, it's become clear that he was also using shorthand to describe his advice

pqrdef

evilplan wrote: »

So I just extracted his advice re gilts in simple form in order to ask the basic question about why he was calling one "long-dated" and the other "short-dated", and after all the conversation here, it's become clear that he was also using shorthand to describe his advice

May reflect American bias. In the USA, linkers (TIPS) don't come longer than 20 years, but worse, you pay tax on the inflation uplift annually even though you don't get it until sale or maturity. That seems to make long-dated linkers rather unattractive.

The case for trackers over managed funds is also rather stronger in the USA, for tax reasons.

Ark_Welder

pqrdef wrote: »

Trading in gilts you'll pay commission and spread and stamp duty...

First two yes, but stamp duty is not applied to gilt transactions.

wriggly

evilplan wrote: »

For this approach, he recommends 20% into long-dated gilts.

My confusion is over a simple issue. In his book, he also mentions index-linked gilts, but calls these "short-dated".

You are confusing two different things - gilts, like all bonds, have an interest rate (how much you get paid for lending your principal) and a term (how long until you get back your principal).

Most gilts are fixed-interest, they pay the same interest rate every year. Some are index-linked, they pay interest based on the rate of inflation, typically RPI.

Both fixed and index-linked gilts have terms ranging from a few months up to decades. Long-term gilts are typically those with 15+ years left until maturity.

Long-term fixed interest gilts are interesting because they typically do well during a period of deflation, a time when most other assets do poorly. However, long-term fixed interest gilts will do poorly when interest rates rise (which is usually during high inflation). This is called "interest rate risk" - it applies to all bonds, but longer-term bonds suffer from it more.

Shorter-term bonds do not have the same "interest rate risk" because they mature earlier before too much damage is done. Index-linked bonds also do not have the same risk because the index-linking boosts them during high inflation, which is related to increasing interest rates. So index-linked bonds are not necessarily shorter-term, but they do sort of behave like shorter-term bonds.

Note, we are in an unusual situation currently, where inflation is relatively high, but interest rates are relatively low.

If interest rates start to rise, long-term bonds will be a bad place to be invested. If, on the other hand, we suffer Japan-like stagnation, long-term bonds might prove a good investment.