Fund Opinion please

talexuser

It's a long time since I had a bond (or similar) fund, and have never invested in a tracker yet - but in the research for a little bit of rebalancing, to try and hedge against the UK doing relatively badly in the next few years vs the rest of the world, came across the Vanguard UK Inflation Linked Gilt Index. This has done reasonably well compared to its relatively safe risk I think. With inflation set to rise opinions would be welcome.

bowlhead99

talexuser wrote: »

This has done reasonably well compared to its relatively safe risk I think. With inflation set to rise opinions would be welcome.

Well, it will have done stunningly well against usual expectations for safe, low return funds, because government bond prices have gone through the roof in recent years as yields fall to all time lows. At the same time, inflation expectations have risen recently which corresponds to people being willing to pay even more for an IL gilt and accept a lower basic yield.

At the moment a November 2017 IL gilt returning 1.25% costs you over 104. You get back 100 and you get 1.25% interest on the 100, but you paid 104 so you lost over 2.5%. You do get paid an inflation kicker so you 'only' lose that guaranteed 2.5% and not some bigger number after inflation. But it's a guaranteed real terms loss.

At the other end of the scale are the bonds due in early 2062. You pay £241 now and you get 45.5 years of 37.5p interest, so you have a total guaranteed loss which works out at about 1.7% compound negative interest. Of course, if inflation was positive, as people expect, you'll get paid more money on top for the index linking. So you might get back more like your full £241 nominal, or even more, not just £124 nominal. But if you pay out £241 nominal and only get back £241 nominal over four to five decades, and inflation is positive, that £241 returned to you is still less than your money back, in real terms.

IL gilts are a hedge against massive inflation. If the current prices are driven by inflation expectations of 3% for the next couple of decades, but inflation expectations later go up to 5%, the bonds would get more attractive. Conversely if expectations fall, the price falls.

It's important to realise that what you pay (or what your bond fund pays) for a bond now is a price that already includes all market expectations for inflation. It's not that you would buy it now thinking inflation will go up to 2% next year from 1% and then you would make a profit when it did. The market already expected it was going to be 2% or 2.5% next year and built that into the bond price today. so if that comes to pass, you don't get rich.

Effectively by buying an IL bond index at current prices you are just guaranteeing your *negative* real-terms yield as somewhere between 1.6 to 2.7% based on the average duration of the bonds that have enough liquidity for the fund to buy in. Less management fees and other OCF and platform fees.

By contrast if you held money as cash in a bank account or 'traditional' bond you would get some positive nominal return, which might well translate to a negative real terms yield, but you would not know how negative it might go because you don't know what RPI will be.

Of course, it is not destiny that you will *definitely* make a real terms loss, because market interest rates may go lower and inflation expectations may go even higher and you will likely not hold to maturity, so you could get out by selling out to another sucker in a year or two at an even more skyhigh price.

Personally I don't have any bond index funds as I guess that active management might be a better way to take a judgement on the credit sector. I don't want to hold the average holding of every single market participant as I may not share their objectives.

talexuser

Thank you bowl for the usual extremely detailed reply. I asked because buying the Vanguard Developed World Ex Uk, and charted it against UK Inflation Linked Gilt Index, after 5 years the former doubled, the latter 70% up, so even against compounded inflation is that not a positive return?

dunstonh

Gilts are normally held in most low and medium risk portfolios. Not higher risk ones. Most of the models have been lowering their gilt allocations in favour alternative fixed interest options in recent times.

bowlhead99

talexuser wrote: »

The latter 70% up, so even against compounded inflation is that not a positive return?

That's pretty much the point though. It was a very very positive return which leaves a very limited amount on the table for the next investor, i.e. you. In fact, what is left is guaranteed to be negative, even before management costs, unless you are lucky enough to get out after a surprising unexpected rise.

Equities give you a chance to actually grow your money and get back an almost unlimited return. Whatever is left in the pot after covering the company's costs and servicing its debts is yours to keep, as the business owner.

By contrast, fixed interest securities have limited upside. You can see what the total return to maturity is capped at: the company or government involved has written the coupon on the face of the bond that they issue. You are destined to receive an exact known return. The only difference with an index linked version is they pay an indexing premium.

The 70% growth you saw the IL fund deliver was not what it paid its investors. It reflects a small amount that it actually paid its investors and a large amount they are asking YOU to pay its investors to help them realise *their* return and lock yourself in to a known real terms loss.

The only way you make money on that deal is if someone in the market during your investment timeline wants to lock in an even larger known guaranteed real terms loss, to buy it off you at a price that gives a profit to you.

That is pretty speculative and no way likely to produce the same real terms return as the five year chart you are looking at - which was something like inflation plus 10% a year. The bonds do not pay inflation plus ten. From here, they pay inflation minus two.

talexuser

Thanks for the explanation which explains succinctly why graphs don't tell you everything. I had around 1/5 in bonds for the first 10 years or so of ISAs from the early 90s, then decided the relative underperformance cf equities was not needed since not cashing anything in for the forseeable, so went 100% stock funds. Just wondering if anything not rest of the world was going to be worthwhile if inflation takes off here for a few years now.