Index linked UK gilt fund performance since 24th Feb 2020

JonBr

Hi all

I'm invested in a L&G fund that holds mostly UK government index linked gilts. Since the recent unpleasantness began, I moved funds from the US market into this bond, luckily avoiding the ~25% drop in US stock valuation. So far so good. I was expecting the gilt fund to hold its own or maybe, even increase in value as there would be lots of other investors doing the same ("flight to safety"). However, over the last two weeks it is down by 12%. This seems a bit counter intuitive to me. Any idea why this is happening (and please don't say "coronavirus" - I am hoping for a more specific technical discussion)?

I seem to have lost £60k from this fund and I'm considering moving it into a cash fund. Zero growth, zero loss (apart from the fees and the effects of inflation, which applies to the gilt fund, too). But before I do, I want to understand why the gilt fund has dropped so far. Is there a hole in my (admittedly limited) reasoning?

Cheers
JonBr

EdGasketTheSecond

I noticed IL was dropping too. I think it is because the expectation is for inflation lower than expected (initial deflation and a possible depression) whereas IL gilts were priced assuming a certain level of inflation. I don't know if they will continue to fall further or not; it depends on people's thoughts on where inflation is headed short-term compared to the inflation expectation currently priced into the IL gilts. Once we are through this phase of deflation I think they will be an excellent investment as gov'ts won't be able to raise interest rates to curb inflation but no idea how low they will go before then.

bowlhead99

The IL gilts will have had:

- upside from the 'gilts' aspect (more attractive to hold government debt paying a fixed coupon when interest rates fall to the floor and new debt is issued at lower coupon) ,and 

- downside from the 'index linked' aspect (the yield will fall to lower than what people were expecting, because inflation will be lower than what people were expecting, because economic activity is drying up for a while and people will be losing jobs and incomes and being more frugal with what they have rather than indulging in consumer spending)

If you look at similar products in the US, iShares TIPS bond ETF as an example is down to $109 from a peak of $122.50 two weeks ago, for similar reasons, so 12% down there too. Though if you held US Tips from the UK  you would have the favourable exchange rate effect as dollar strengthened against pounds, giving less of a loss in sterling.

JonBr

Interestingly, there was a spike in value on the 9th March. I was feeling quite happy at that time, but since then it's all gone a bit pear shaped. The spike seems to correlate with the Fed dropping the US interest rate (odd, as this fund is UK gilts only, plus - inexplicably - some Railtrack shares).
(I'd have posted a link to the info page (with handy interactive graph comparing it to the FTSE Actuaries UK Index-Linked Gilts Over 5 Years benchmark, but I'm not allowed to as a recent forum member.)

So, if UK inflation's on the way down perhaps I should accept the loss and shift to cash. But then again, maybe the market has that drop already priced in?

EdGasketTheSecond

A good question. I think if you dig hard enough you can find out what inflation rate is priced-in (you'll have to google it) and then you can make a decision about whether that is correct or not given the current circumstances and act accordingly. There is no simple answer only opinions.

newatc

Isn't this because of the move to pay future interest payments based on CPI rather than RPI. I seem to recall it's coming in around 2025. Can't recall where I read this but maybe the news has been lost within the pandemic environment.

EdGasketTheSecond

I don't think they could change the rules like that on existing gilts could they? It'd be like breaking a contract.

bowlhead99

newatc said:

Isn't this because of the move to pay future interest payments based on CPI rather than RPI. I seem to recall it's coming in around 2025. Can't recall where I read this but maybe the news has been lost within the pandemic environment.

The treasury's consultation started earlier this month and runs until April 22. But it was already known last year that the consultation was going to start, leading people to start to bake in lower inflation expectations last September when the govt said they would start a consultation process this Jan. That got deferred until budget day (https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/871691/RPIM_final.pdf)

The government has already said that changes would not come in any earlier than 2025, but the Statistics Authority people have free reign to change the calculation methodology from after 2030 (they would like to do it as soon as they are allowed, but won't do it earlier than that because some old gilts issued before 2002 have terms about needing to pay compensation if a change to RPI was 'materially detrimental' to holders; the last of them matures in 2030). It had been hoped that the consultation would provide some clarity on when the government would look to push it through (i.e. when between 2025 and 2030) but this hasn't been made clear. Really that part of the consultation on 'establishing the timing' just asks questions about impact on holders and on the market. So there is likely to be some 'erring on side of caution' while people wait for the consultation period to close and then the results of the consultation to be confirmed by Treasury.

The last full DMO consultation (getting on for a decade ago now) was about perhaps starting to issue CPI-linked bonds instead of RPI linkers. Government at the time decided not to do that as it would likely not be cost effective in terms of the demand from people who would take it up, and had some risks/ uncertainties.  Whereas this consultation is about changing the methodology of RPI itself.

As this consultation was always in the pipeline (just the timelines haven't been signposted as well as some hoped they might be) the launch of the consultation itself will not have caused a massive effect on the inflation expectations. Really that is coming from events in the real economy, and the fact that US treasury inflation-protected securities have dropped by similar levels (while not being affected by how we choose to calculate our RPI) bears this out. IMHO etc.

JonBr

Fell again this morning. Have bitten the bullet and moved to a cash fund. That's £90k lost in one month - still, could have been worse I suppose.

Malthusian

JonBr said:

Fell again this morning. Have bitten the bullet and moved to a cash fund. That's £90k lost in one month - still, could have been worse I suppose.

Could also be a lot better if you decide to stop voluntarily losing money. Assuming you don't need £90k for your short-term living expenses.

EdGasketTheSecond

But where are you looking at the price? No good looking at the L&G fund price because that is historic. Looking at IL ETF (e.g. INXG) fund price this morning which will be real time prices, it is up 6.2%. The L&G fund should follow in a day or two but hopefully you will benefit from today's uplift if they switch you at today's price and not the price 1 or 2 days ago.