UK Index Linked Bonds

kernow1234

Hello all,
I have some investments in UK index linked bonds and have held them for a number of years (bought initially on the advice of an IFA).  They did very well for a number of years, but anyone familiar with them probably already knows the 30% odd fall in value of these funds in the last year (eg. Axa Sterling Index Linked Bond Fund Z).
I've been hunting around online and can't find much information to shed light on this and also on what the future might hold - I know selling after a crash is generally not a good idea, but I'd love to have a few more resources/opinions etc to better understand why this large fall happened and also whether they are a good hold going forward.
Thanks in advance for any help offered!

GeoffTF

Here is article written long before the recent interest rate rises:

https://monevator.com/why-uk-inflation-linked-funds-may-not-protect-you-against-inflation/

Horses and stable doors.

Linton

The fall in value of IL bonds is due to the general rise in intrerest rates.

A few years ago inflation was forecast to be at say 2.5% long term whereas general interest rates could have been at 1% or less.Therefore someone seeking gains could be much better off buying an inflation linked bond rather than a fixed rate one.  So  the price of inflation linked bonds rose well above par - sufficiently so that if inflation was as expected the actual return based on purchase price would be similar to a corresponding fixed rate bond.

Now interest rates are above expected long term inflation rates inflation linked bonds are much less desirable and have fallen in price to around par.  The extra money you paid for IL bonds a few years ago is irretrievably lost, barring another collapse in interest rates.

Looking forwards IL bonds are priced attractively if your aim is to match inflation.  If you are just looking for guaranteed high rates of return that may or may not exceed inflation you would be better off with fixed rate bonds.  Which is at it should be

JohnWinder

To keep it simple(r) let’s assume interest rates haven’t changed for the last 5 years. When investors now go to the market to buy a 10 year government bond they have a choice of buying a linker which is paying let’s say 1%/year interest, or they can buy a ‘normal’ or nominal bond. The linker interest payment will increase with each payment by the inflation during that last period, and when the linker matures you will be paid its £100 face value plus however much inflation has increased the value of £100 over the life of the bond - for 10 years that could be 30% more. You get neither of those benefits with nominal bonds, as the maturity value is only £100 and the interest payments never increase. You can see the disadvantage of the nominal bond, and so nominal bonds pay a higher interest rate than linkers do so as to compensate the buyer for not getting inflation protection. How much more interest they pay depends on how much inflation the market thinks there will be over the next 10 years; that way there is no anticipated advantage to buying a linker or a nominal bond if inflation turns out as expected.
But imagine if inflation turns out to be more than expected after 10 years; the linker bond was a better choice, and vice versa. So, when choosing bonds, ask yourself ‘am I more worried about inflation higher than ‘normal’ or less than ‘normal’ (or expected)?’

One of the reasons your fund value has dropped so much is the rise in interest rates that has occurred over the last year or so. Some (many?) of your fund’s bonds were bought earlier when interest rates were low, and because those bonds’ interest rates are fixed (vide infra), they are condemned to pay the lower interest for their (not your) lifetime. And the bitter icing on the cake, your fund’s bonds have a long life, maturing in 2050 and beyond for some. That’s why long term bonds (yours) respond more dramatically to interest rate changes than short term bonds. The compensation is that longer term bonds usually give higher returns (because you’re more exposed to that interest rate (change) risk).

What to do? To minimise this interest rate risk (buy short term bonds), but to get the best returns (buy long bonds). The compromise point is to match how long term the bonds are with how long term your investing horizon is. There’s some simple maths if you’re still interested, but qualitatively your bond fund is best suited to a ?20 year investment horizon; is that you?
If so, you can expect your bond fund to slowly start picking up, because as its bonds mature and are replaced by new bonds paying higher interest rates, it’ll be earning more, but it will take a good few years (since the fund holds long maturing bonds).

What is a ‘fixed rate’ bond? Well, as Alice said, the question is whether you can make words mean many different things. Linkers have a fixed coupon rate, eg 1% or 1.5%, but they will have a variable coupon payment with inflation; I think that qualifies them to be called ‘fixed rate’ bond. Nominal government bonds have a fixed coupon rate, also qualifying them to be called a ‘fixed rate’ bond. There are, in a minority, other bond issuers who offer floating or variable rate bonds, which would disqualify them from being called ‘fixed rate’ bonds. Humpty, take note.
https://www.bogleheads.org/wiki/Outline_of_bonds

kernow1234

Thank you very much for your informative responses!
So, given that the last year has been an unusual shock of inflation and interest rate rises caused largely by the Ukraine conflict, and that this inflation is expected to fall almost as sharply as it rose, and therefore interest rates may well do the opposite - would that make the value of these index linked funds expected to rise rapidly as this takes place.  I'm not expecting a 50-60% increase to take them back to the earlier values, but just trying to exit at not the worst moment!

Linton

If interest rates fall index-linked gilt prices will rise.  However historically, interest rates were steadily falling for abut 40 years until recently when there was one of the steepest rises ever, the latter causing the collapse in IL gilt prices.  Historically again current interest rates are not high - index linked gilts are now trading close to par.

The rise in interest rates was not primarily due to the Ukraine war. Central banks have been wanting to increase interest rates to a more reasonable level for some time. It was not reasonable that people were able to borrow money for virtually zero interest.  However Ukraine and other events seem to have made the rise much faster than expected.

So all other things being equal it seems reasonable to expect that IL bond prices will remain close to current values for some time.  Surely the reason for buying IL bonds is to match inflation.  Trading at par, that is what IL bonds will now do.

TheGreenFrog

If objective is matching inflation then I suppose relevant to this is whether OP's investment is in a tax free or taxed account (and if taxed what OP's marginal tax rate is).  If taxed, inflation will not be matched on a net basis and certain non-linked gilts are worth considering as an alternative.

GeoffTF

TheGreenFrog said:

If objective is matching inflation then I suppose relevant to this is whether OP's investment is in a tax free or taxed account (and if taxed what OP's marginal tax rate is).  If taxed, inflation will not be matched on a net basis and certain non-linked gilts are worth considering as an alternative.

If you hold gilts directly, they are exempt from Capital Gains Tax. Some gilts, including index linked gilts, have coupons of 0.125%, so there is not much income tax to pay either.

sgog

GeoffTF said:

TheGreenFrog said:

If objective is matching inflation then I suppose relevant to this is whether OP's investment is in a tax free or taxed account (and if taxed what OP's marginal tax rate is).  If taxed, inflation will not be matched on a net basis and certain non-linked gilts are worth considering as an alternative.

If you hold gilts directly, they are exempt from Capital Gains Tax. Some gilts, including index linked gilts, have coupons of 0.125%, so there is not much income tax to pay either.

What is a good (low-cost) way of buying linkers directly?

TheGreenFrog

GeoffTF said:

TheGreenFrog said:

If objective is matching inflation then I suppose relevant to this is whether OP's investment is in a tax free or taxed account (and if taxed what OP's marginal tax rate is).  If taxed, inflation will not be matched on a net basis and certain non-linked gilts are worth considering as an alternative.

If you hold gilts directly, they are exempt from Capital Gains Tax. Some gilts, including index linked gilts, have coupons of 0.125%, so there is not much income tax to pay either.

Agree.  But for various reasons the nominal bond with equivalent coupon will be more tax efficient than the linker (just a factor, rather than a reason, to prefer the nominal).  For that and for other reasons (e.g. liquidity/pricing) I would have to have real conviction to go for the linker over the nominal.

OldScientist

sgog said:

GeoffTF said:

TheGreenFrog said:

If objective is matching inflation then I suppose relevant to this is whether OP's investment is in a tax free or taxed account (and if taxed what OP's marginal tax rate is).  If taxed, inflation will not be matched on a net basis and certain non-linked gilts are worth considering as an alternative.

If you hold gilts directly, they are exempt from Capital Gains Tax. Some gilts, including index linked gilts, have coupons of 0.125%, so there is not much income tax to pay either.

What is a good (low-cost) way of buying linkers directly?

iweb allow this (at £5 per transaction, but there is a bid-ask spread too), but only over the telephone (not online). From memory, it took about 10 minutes or so per bond (I am pleased to note that the person at the other end took great care in ensuring accuracy). Generally the number of transactions with each bond is so small that I took some small pleasure in seeing mine sit on the LSE page for the whole day (sad, isn't it!).

Quite a few other brokers also allow purchase of individual bonds (although Vanguard don't and I don't think Fidelity do either).