Inflation-linked or regular gilts?

aroominyork

A thread over recent days has given me a much better understanding of fixed interest, and I can now see how to structure this part of my portfolio through a mix of mostly global bonds (either govt or aggregate), plus one or two strategic bond funds and possibly some UK gilts. The main purpose in holding UK, rather than global, gilts (apart from cheaper OCF) seems to be for inflation-linked gilts. And that is my next question… linkers seems to have consistently outperformed ‘standard’ gilts over the last 20 year except for brief periods – such as the GFC, just the type of situation for which we hold gilts… – so why is this, and how do you decide what type of gilts to hold?

JohnWinder

I've got no idea. But yields are usually higher on longer duration bonds, so you’d want to check that you were comparing funds with similar durations, and not just now but during the last 20 years.
Nominal bonds pay you something for the inflation that is anticipated before the bond matures. If folk guess inflation will be 1%, then you’d expect a comparable linker to yield 1% less than the nominal bond as the capital value and coupon it pays will rise by 1% each year (if that’s what inflation turns out to be) and so both bonds have similar real returns - of course they will, or people would only buy the ones with the higher real returns. But if inflation suddenly jumps, the nominal bond has no protection against that unexpected inflation, while the linkers go up pari passu. Further, if nothing happens to inflation, but everyone thinks it’s going to jump, that will make the demand for linkers stronger and push up their price - and the value of the linkers fund.
At GFC type times liquidity for some less widely held assets like linkers can fall; when liquidity falls because there are not enough traders in the market or they’re not offering to buy/sell enough securities, you can get wide buy/sell spreads which show up as big dips/rises in prices on your chart.
Lastly, check if every country’s inflation linked bonds behave as your graph shows. I don’t think they do.

tebbins

The main reason would be the market's implied breakeven RPI estimate (he difference between the coupon and real yield is what the market expects inflation to be over the maturity of the bond) being an underestimate.
I wouldn't call the outperformance consistent. It's more like both types of gilts usually behave the same, and of the times when they didn't, more of those times favoured linkers.
I checked and by decade, linkers pulled ahead by 10% by the end of the 2000s, you could argue that was projecting higher inflation through the recovery which was true for the early 2010s at least.
1/1/2010-1/1/2020 linkers pulled ahead another 25% or so, but you can see a big spike of that happened after the referendum. 1/1/2010-23/6/2016 linkers pulled ahead about 10%, they tend to have longer maturities, so would have been boosted more by falling rates through the 2010s coupled with higher actual inflation then. 23/6/16-1/1/2020 after the referendum linkers jumped ahead another 10% but there was no more significant variation really until this year, which of course represents the current inflation scare. 

I'm using relative numbers here, eg if linkers return 65% and gilts 50% linkers have outperformed by 1.65/1.5=1.1-1=10% not 15%.

I don't need to worry about managing volatility yet but i do worry about inflation, so I hold some linkers but not gilts.

coastline

Decent summary .

Fixed Income Investor

Not so good review here.

David Stevenson: I wouldn't touch inflation-linked bonds - Citywire

Prism

Just to add another choice into the mix, CGT and PAT both use unhedged US TIPS as their index linked bonds rather than UK linkers. Basic reason seems to be that UK linkers are more expensive.

Anyway, these sorts of decisions are beyond me so I will stick with global government bonds (hedged)

tebbins

I can't comment on why they don't hedge them but US TIPS have much lower average maturity hence less interest rate risk, are more liquid, and at a guess I could say US CPI is perhaps less volatile/more predictable than UK RPI as the US is much less dependent on/vulnerable to international trade.

aroominyork

coastline said:

Decent summary .

Fixed Income Investor

JamesRobinson48 said:

But personally I don't currently hold linkers, as I don't need the expensive 'insurance policy' against inflation that they provide.

Thanks - helpful summary indeed in Fixed Income Investor including "The natural buyer of index linked gilts is a large pension fund, the trustees of whom need to match long-term index-linked liabilities. Such investors are prepared to give up a degree of performance in the security in return for a government-guaranteed hedge against inflation. Thus, all things being equal, one might expect index-linked gilts to underperform other more risk-positive assets over time."

I wonder how much you forego as the price of the insurance policy, if inflation stayed precisely at the level estimated by a linker, ie so that the return would be the same as a non-linked gilt?

Whether or not to buy them needs more mulling over, though I don't think I will at the moment given the recent rise in price (which, of course, might make them seem cheap if the much-discussed spike in inflation turns into something mroe sustained).

Prism said:

Anyway, these sorts of decisions are beyond me so I will stick with global government bonds (hedged)

... for which the only stand-alone (index) option seems to IGLH, or do you have them wrapped up in a multi-asset fund?

Prism

aroominyork said:

 for which the only stand-alone (index) option seems to IGLH, or do you have them wrapped up in a multi-asset fund?

Yeah, IGLH seems to be the standard option for G7 Government bonds with XGSG for a slightly bigger country range (10 if I remember correctly rather than 7). A new one EGOG seems interesting too with a lower charge but I have never used it.

george4064

If in doubt, go for a bit of both (50/50 maybe).

masonic

tebbins said:

I can't comment on why they don't hedge them but US TIPS have much lower average maturity hence less interest rate risk, are more liquid, and at a guess I could say US CPI is perhaps less volatile/more predictable than UK RPI as the US is much less dependent on/vulnerable to international trade.

Presumably because if UK inflation took off it would likely coincide with a weakening in Sterling, which would allow someone investing in unhedged US TIPS to benefit from the exchange rate movements. However, if exchange rates move in the other direction for other reasons, investors will suffer the currency risk. If the position is hedged, as well as the cost offsetting the benefit of holding them, they would only be of benefit if the inflation was global in nature. As you say, the US economy is quite different to the UK, so no reason to think there's a free lunch to be had buying a cheaper investment tracking an entirely different index.

At todays inflation level, all low risk investments promise negative real returns (and are around the same ballpark if held to maturity), including cash, gilts, quality foreign government bonds, and index linked bonds. Different head winds will affect them in different ways, so it seems sensible to hold a mixture if you don't know what the future holds.

JohnWinder

JamesRobinson48 said:

aroominyork said:

I wonder how much you forego as the price of the insurance policy, if inflation stayed precisely at the level estimated by a linker, ie so that the return would be the same as a non-linked gilt?

Well, one indication of the effective annual 'insurance premium' cost could be the 2.5% - 3% p.a. implied negative real yield at which the linkers currently trade.

I strongly doubt that that is a suitable indicator of the 'cost' of the 'insurance' for inflation protection. Could you explain why you think that, as concretely as possible for this simple mind?

The cost is inside that negative yield somewhere, and it would be there even if the yield was positive, but it wouldn't be 2%/year, I think.

Part of the linkers yield is because it's a bond, just as any other bond yields something (even if it's negative); another factor determining the yield for a linker is protection against the expected inflation (its yield will be less than its nominal brother because inflation will help it up); and the factor we're interested in, the insurance against unexpected inflation, costs something.