Buying an Index Linked Gilt.

[Deleted User]

Thanks, althought I think the interest payments are 0.5% of the inflation linked £100 so the next one will be based on roughly £136, not £100.

I just thought of an easier way to look at it. Minus 1.7 for 30 years is 50% loss. The £258 cost of the bond for £136 capital is close to 50% loss..

masonic

newbinvestor wrote: »

Thanks, althought I think the interest payments are 0.5% of the inflation linked £100 so the next one will be based on roughly £136, not £100.

Interesting point, since the interest payments going forward are not known the yield can only ever be a guide. Since including accrued index linking in the interest payments makes the calculated yield diverge from the stated value, it suggests the stated value does not include index linking to interest, which it could be argued is the right way to do it. But it would be sensible then to strip out index linking from the dirty price and redeem at £100, which causes exactly the same divergence.

I just thought of an easier way to look at it. Minus 1.7 for 30 years is 50% loss. The £258 cost of the bond for £136 capital is close to 50% loss..

That will work when the interest rate is very low, but when it is a few percent rather than 0.5%, it won't work as well.

Edit: it doesn't work so well
-1.7% = (1-0.017) = 0.983 as a decimal
0.983^30 = 0.60 or a 40% loss

£136/£258 = 0.53 or a 47% loss

[Deleted User]

DMO website says
Index-linked gilts differ from conventional gilts in that both the semi-annual coupon payments and the principal payment are adjusted in line with movements in the General Index of Retail Prices in the UK (also known as the RPI).

masonic

newbinvestor wrote: »

DMO website says
Index-linked gilts differ from conventional gilts in that both the semi-annual coupon payments and the principal payment are adjusted in line with movements in the General Index of Retail Prices in the UK (also known as the RPI).

Agreed, but index linking shouldn't be included in yield calculations. The index linking is added on top. In other words the yield is in real terms, it is not a nominal yield. There's a good reason for this: the nominal yield is impossible to know in advance of the gilt maturing.

EdGasketTheSecond

Doesn't it boil down to:
If inflation is higher than expected you will make a gain and if lower then you won't make quite so much of a gain or even a loss. Assuming stable interest rates.
If interest rates rise faster than expected and inflation not so much then you will make a loss and vice-versa.

[Deleted User]

Another one I see is
36 years remaining. Coupon RPI + 1.25%
Index ratio is 1.51478 I think from DMO. So the £100 is now £151
Clean is £250, therefore dirty is £250*1.51478 = £378

1.25% of the £151 is £1.89. x36 years = £68 interest. Add to the £151 = £219 final value (plus RPI). £219 for £378 paid is a £159 loss. £159 loss on £378 is minus 42%. Over 36 years this is minus 1.17%. The website says minus 1.732. This is one of the most confusing things ever.

masonic

newbinvestor wrote: »

1.25% of the £151 is £1.89. x36 years = £68 interest. Add to the £151 = £219 final value (plus RPI). £219 for £378 paid is a £159 loss. £159 loss on £378 is minus 42%. Over 36 years this is minus 1.17%. The website says minus 1.732. This is one of the most confusing things ever.

If you just plug in the clean price of £250, interest payments of £1.25 and £100 redemption value, then you get the right answer, as you do with the former example, so I think that is the basis of the calculation. Alternatively you can multiply everything by 1.51478 and you'll come out with exactly the same answer.

MarkCarnage

Yield calculations on ILG still give me nightmares from my exams 25 or more years ago......

Some observations.....

Eye teeth would be given for the real coupon of over 4% from that 1992 linker today!!

Using break even inflation vs conventional gilts helps to contextualise which is better value at a given future inflation rate assumption

The 8 or 3 month lag is important for the exact maths of the calculation, but is unlikely to be a game changer unless there is a sharp change in inflation over these periods. With a series of ILG of different maturities the risk here will likely even out.

With such low yields attaching to linkers, the duration of these bonds is pretty lengthy, and long dated ILG will be more volatile than conventional gilts of the same maturity, and whilst both will be very vulnerable to changes in real yields, linkers will be more so.

Buying linkers at current levels will embed a negative real return if held to maturity. The compensation for this is a pretty guaranteed hedge with no cap to RPI which in itself structurally overstates actual inflation due to methodology flaws.

US TIPS still have a positive real yield but for a UK investor introduce either basis risk on inflation and/or currency risk.