Should I get out of my inflation linked gilt index fund?

boredfolio

8-9 years ago I came by a lump sum and invested it with the help of Tim Hale's Smarter Investing, this forum, etc. I ended up divided mainly between Vanguard LifeStrategy80%, Vanguard inflation-link gilt index, and cash. This seemed fairly boring and I stopped checking up too often.

I've recently checked, and seen that the Inf-linked gilt fund has dropped drastically in the last 3 months. Internet searching reveals articles whose technical details I don't follow very well, but which refer to Inf-linked gilts as 'astronomically over-valued' etc. The relevant paragraph in Hale's book (quoted below) mentions volatility but nonetheless treats such funds as a Defensive Asset. Was I naive to put a big slab of my money in such a fund? Obviously I'm wondering whether to sit tight (indeed, is this a buying opportunity?) or sell before the fund does a Woodford.

Any comments very gratefully received!

[Tim Hale: "Your other option is to own a fund... Most products tend to replicate the entire market for index-linked gilts, with an average maturity of about 15 years and duration of 13 years or so. That makes them quite volatile. If that worries you, you could hold some cash to reduce the volatility of your defensive assets. Over time you will receive inflation protection as you still own a basket of index-linked gilts."]

Linton

I am afraid that shows the danger of blindly following old investment advice. When Tim Hale wrote his book his advice may have been sound. However since then interest rates have fallen to unprecedented levels which in my view has significantly reduced the value of index linked gilts as a valuable defensive asset.



However although the Vanguard fund has dropped by about 10% in the past 1-2 months this follows a larger rise in the previous year and the price has yet to drop back to what it was.


So what to do now? I would sell since you are still showing a profit and the fund is not really doing what you bought it for. You could simply reinvest the money into VLS80 or perhaps decrease it to VLS60.


There is no chance of a gilt fund "doing a Woodford". The shares owned by Woodford may or may not have an intrinsic value that someone wants to pay for and may or may not be worth something in 10 years time. No-one knows.


By contrast a gilt is guaranteed by the UK Government to return the originally invested money plus interest plus, in the case of index linked gilts, inflation on maturity. So it always has a known intrinsic value which can be calculated exactly from the current market interest rates. This means that there is no such thing as a "buying opportunity". A gilt is always worth what it should be worth given current conditions and there is always a market for it. At least for as long as the UK Government exists.

boredfolio

Many thanks. Is there something in particular that triggered the drop three months ago? Rates have been low for ages, haven't they?

Also, you say "A gilt is always worth what it should be worth given current conditions". I take it by "worth" you don't mean its price, which can be inflated? Does this mean that the worth of the gilts owned by the tracker fund provides a known floor below which the price of fund units can't or shouldn't fall?

Lastly, given that I also followed old investment advice in holding VLS80 (and for that matter cash), I wonder if there's some looming real-world situation that will make that course of action look similarly blind?

Prism

These kind of drops are not uncommon for this kind of fund. In terms of volatility its around the same level as a typical world equity fund. So a 10% drop is quite normal. This one came just after a 10% rise so its currently at the same level it was at during June.

What makes it high on the risk scale is its focus on long duration bonds which means if there is a hint of a change in global interest rates the value can shift abruptly in either direction

Thrugelmir

boredfolio wrote: »

I've recently checked, and seen that the Inf-linked gilt fund has dropped drastically in the last 3 months.

View your portfolio as a whole. Individual components will underperform and some overperform over any given time frame. Rebalance your portfolio in a structured manner.

boredfolio

View your portfolio as a whole. Individual components will underperform and some overperform over any given time frame. Rebalance your portfolio in a structured manner.

Thank you. My question, following from my internet searches ('astronomically overvalued'), was really whether circumstances have changed so as to alter the role/point of such a fund as a defensive asset. Linton's reply above seems to suggest precisely that, and he recommends I sell.

On the other hand, my holding has so far grown well above inflation (disregarding the recent rise and drop), so a drop is par for the course.

JohnWinder

We don’t know what your age, circumstances or other assets and liabilities are, so we can’t comment on your VLS, indexed gilts and cash as being good or bad.
You might want to spend some time getting to understand more about your current investment choices so you can properly appraise the advice that’s dished out in this forum, because it’s not clear to me that you should be jumping in to sell anything you’ve got just now. Try some other books, particularly bond books since that’s your question.

If you still want defensive assets, UK government bonds are for you. They’ve very little risk of default - your money is returned on maturity; think about getting your money back on equities when companies go broke. When the next global financial crisis hits and shares take a long dive, investors move their money into safe government bonds sending their price up - you hope that’s how it will work, anyway. And even if it doesn’t, bond prices shouldn’t fall anything like share prices.
Yes, bond values are sensitive to interest rate moves; as rates fall, bond prices rise (if you’re holding an older bond with a higher interest rate, of course people will pay you more for it than buy a new one of the same face value with a lower interest rate).

Bonds’ interest payments include a bit to cover anticipated inflation (to compensate you for getting your money back at maturity, but that money buys less then). Inflation linked bonds guarantee your investment will keep up with inflation no matter how great, even if it’s more than anticipated, by increasing their interest payments with inflation as well as increasing their maturity value by inflation. But to get the benefit from such bonds there has to be inflation above the expected; if so, you win compared to cash or nominal bonds. But if inflation turns out to be less than expected, you lose compared to nominal bonds and can lose compared to cash. That’s why you might own both inflation linked and nominal bonds (or cash as a substitute - starting to sound like Hale’s advice?), because you don’t know how inflation will go in the next 15 years. And you might own them in equal portions; but wait, is unexpected inflation or unexpected deflation more of a threat to you? Depends on your circumstances.

Your bond fund’s duration tells you a lot; 13 years. The longer, the more volatile it’s price will be, but the better return it should give long term. For each 1% change in interest rates you could expect a 13% (ie the duration) change in value; that’s a lot for a bond fund. As well, if you were convinced inflation was tamed for the next 15 years, and we faced likely deflation, you wouldn’t buy inflation linked bonds - you’d buy nominal if it was bonds you wanted. That might explain a fall in value. But you’re smarter than to think you can guess inflation rates for the next 15 years, so you don’t speculate like that.

For interest, find out who’s been writing that your fund is astronomically overvalued and see if they might have a conflict of interest.

Your second post suggests you last acted ‘blind’. Take the time to research all this a bit better, so next time you act it’s not blind; and I don’t mean just read these posts - do some serious reading.

Thrugelmir

boredfolio wrote: »

Thank you. My question, following from my internet searches ('astronomically overvalued'), was really whether circumstances have changed so as to alter the role/point of such a fund as a defensive asset. Linton's reply above seems to suggest precisely that, and he recommends I sell.

The question I always ask myself before changing tack is whether I've identified a better opportunity elsewhere. Portfolio's should be broad and diversified. Your personal objectives should form the basis of how much risk you should expose yourself too.

Linton

boredfolio wrote: »

....

Also, you say "A gilt is always worth what it should be worth given current conditions". I take it by "worth" you don't mean its price, which can be inflated? Does this mean that the worth of the gilts owned by the tracker fund provides a known floor below which the price of fund units can't or shouldn't fall?

......

When I said "A gilt is always worth what it should be worth given current conditions" I did mean price. Any share you buy could increase in price by orders of magnitude in 10 years or could drop to zero. You dont know what will happen. So the "correct" price is unknown.



A gilt is different. If you buy one now you know exactly what return in £s you are going to get each year up to the date it matures. The price may go up or down in the mean time but that doesnt change the end result. So you are buying a guaranteed income. That guaranteed income has a correct price that depends on current interest rates. £100 in 10 years time is worth less than £100 now because if you had £100 now you could put it into a guaranteed interest 10 year account and get more than £100 in 10 years time. The BoE publish a formula to calculate the gilt price from the interest rate.



Next basic point: The amount you get back from a bond is based on the face value, normally £100. If the price goes up the effective yield goes down and vice versa. You as a private investor have to buy bonds at the current market price.



Barring hyper-inflation or the collapse of the UK state, at any point in time a gilt has a pretty well defined price within bounds. If the price drops too far below £100 buying the gilt would be a guarantee of a high profit so investors would queue up to buy it. Conversely if the price were to rise too high you would never get your money back and investing in the gilt would be pointless.



At the moment gilt prices are within striking distance of the upper bound, there is a lot more room for prices to fall than to rise.



If you bought individual gilts that would not matter because you can hold them to maturity and get the return you expected. However if you hold a gilt fund, in general when you sell the fund you are selling the underlying gilts at a wide range of times to maturity and so you are dependent on the then current prices.