Index Linked Gilts (Dirty prices)

jake_jones99

zagfles said:

jake_jones99 said:

I will lay out my rationale for investing in this gilt, both for my future reference and in case you have any comments.
I downloaded the monthly percentage RPI data (Jan 1987=100) from 1948-present from the ons website. I am computing a worst case scenario, by selecting 20 values when the RPI peaked, and assuming I would buy at that point, trying to compute how steeply the RPI can fall. Assuming the peak is 13.5% (current RPI), I computed the potential falls in percentage RPI in a 12-month period, by assuming a fall proportional to the selected 20 peaks. 

Apart from an outlier during the financial crisis in 2008 when you would have lost ~3.5%, every other case gives you a positive return. The average is 6.12% (remember these are worst case scenarios). However, I find 2008 to not be a relevant example given the RPI was much lower ~5%, but might be wrong here.

In conclusion, it seems that, unless very unlucky, this gilt will likely give you around 6% tax-free in a 12 month period, which beats savings accounts by far. Please let me know if you see any major flaw. Otherwise I will be back in a year to re-assess my own analysis. 

Disclaimer: I am aware this is just a speculation and not a guarantee, but it confirmed my intuition that it's very unlikely that the RPI would get very low in a year. 

Looks like the buy price is 100.85 so that'll chop almost 1% off, and there'll be dealing costs, maybe platform costs, so need to chop those off the gain too.

That's true. There are brokers such as AJ Bell that charge £10 per transaction, and the custody charge is capped at £3.5, so if you invest enough it doesn't take a lot from the gain. But the 0.85% should be deducted from the gain as you rightly noticed.

coyrls

If you keep until redemption, your real return is known at the time you purchase.  If they are trading at par then you will keep pace with RPI.  The nominal return is unknown.  When you say "profit" do you mean relative to savings accounts?  If so you would need to compare to one year fixed term accounts to match keeping your bond until redemption in March 2024.

Don't forget to include the cost of purchase in your comparison.

jake_jones99

coyrls said:

If you keep until redemption, your real return is known at the time you purchase.  If they are trading at par then you will keep pace with RPI.  The nominal return is unknown.  When you say "profit" do you mean relative to savings accounts?  If so you would need to compare to one year fixed term accounts to match keeping your bond until redemption in March 2024.

I agree the return is unknown, I tried to look at worst case scenarios. No, the "profit" is relative to initial investment. I looked at one year fix savings accounts and they're roughly 4.9%. Out of which 20% (or more for higher rate tax payers) goes to Downing street. 

coyrls

jake_jones99 said:

coyrls said:

If you keep until redemption, your real return is known at the time you purchase.  If they are trading at par then you will keep pace with RPI.  The nominal return is unknown.  When you say "profit" do you mean relative to savings accounts?  If so you would need to compare to one year fixed term accounts to match keeping your bond until redemption in March 2024.

I agree the return is unknown, I tried to look at worst case scenarios. No, the "profit" is relative to initial investment. I looked at one year fix savings accounts and they're roughly 4.9%. Out of which 20% (or more for higher rate tax payers) goes to Downing street. 

At current prices you will get your investment back with no loss relative to RPI, i.e. you are protecting against inflation.

Dh6

Every time I think I’m beginning to finally understand bonds, threads like this pop up to confirm I still know nothing! 🙈

jake_jones99

Dh6 said:

Every time I think I’m beginning to finally understand bonds, threads like this pop up to confirm I still know nothing! 🙈

The DMO website explains in great detail, but does require some time investment. The inflation linked bonds discussed here are more complex than regular bonds, so no need to worry.

easysaver

Viewing this simplistically, you have three options if you've decided to lock up your cash for about a year secured by HMG.
1) IL gilt, TR24 (maturity 22/3/24), current real yield 0.55% (according to tradeweb)
2) conventional gilt, either TN24 (maturity 31/1/24) 1/8% coupon, nominal yield 4.13% or...
TN24 (maturity 22/4/24) 1% coupon, nominal yield 4.28%
3) fixed rate FSCS protected to £85k, best 1 year rate is currently 5%
Considering the gilts....
If inflation is more than the conventional gilt nominal yield minus the IL gilt real yield (about 3.75%) over the period (or more accurately lagged by 3 months), then the IL wins. This is simply implied inflation expected by the market, see:
https://www.bankofengland.co.uk/statistics/yield-curves
If you opt for conventional over IL gilt you'd then have to crunch the numbers given your marginal tax rate, gilt coupon (remember gilts are free of capital gains tax), and fees (both purchase and holding, I'd recommend a fee free broker) to work out whether a conventional gilt pays more than a fix (notwithstanding the £85k FSCS limit, although you can spread your cash around).

jake_jones99

easysaver said:

Viewing this simplistically, you have three options if you've decided to lock up your cash for about a year secured by HMG.
1) IL gilt, TR24 (maturity 22/3/24), current real yield 0.55% (according to tradeweb)
2) conventional gilt, either TN24 (maturity 31/1/24) 1/8% coupon, nominal yield 4.13% or...
TN24 (maturity 22/4/24) 1% coupon, nominal yield 4.28%
3) fixed rate FSCS protected to £85k, best 1 year rate is currently 5%
Considering the gilts....
If inflation is more than the conventional gilt nominal yield minus the IL gilt real yield (about 3.75%) over the period (or more accurately lagged by 3 months), then the IL wins. This is simply implied inflation expected by the market, see:
https://www.bankofengland.co.uk/statistics/yield-curves
If you opt for conventional over IL gilt you'd then have to crunch the numbers given your marginal tax rate, gilt coupon (remember gilts are free of capital gains tax), and fees (both purchase and holding, I'd recommend a fee free broker) to work out whether a conventional gilt pays more than a fix (notwithstanding the £85k FSCS limit, although you can spread your cash around).

TR24 dropped in value around 10% in the last months for some reason, such that now it's close to par. For a fair comparison with the conventional gilts or fixed rate deposits we should look at inflation uplift which brought up the value by >13% lately, which will keep going to maturity (probably at reduced levels). My point is even if the bond keeps dropping in value, I don't really care since I am holding it to maturity. So in reality, all I need to compare is RPI vs interest rates. Indeed, I need a higher average RPI than the interest rates mentioned for it to make sense. My calculations above shows there is some hope for that. But I also have capital invested in short-term bonds, so we will see after 1 year which one will have been more worthwhile. 

TheGreenFrog

Personally, on a short maturity gilt, and especially an ultrashort like 24, I would prefer the conventional over the IL. Even if I like the proposition that inflation will be higher than the rate implicit in the pricing difference between the IL and the conventional, the dealing spread on the IL (although it seems to vary wildy) can be a lot more than on the conventional. This can make a big difference to yield given the ultrashort maturity so I have to have more conviction in the inflation proposition.

I hold both TR24 and TN24 but mostly the latter.  Am currently doing better on the conventional due to high spread when I bought the IL.

TheGreenFrog

jake_jones99 said:

I am computing a worst case scenario, by selecting 20 values when the RPI peaked, and assuming I would buy at that point, trying to compute how steeply the RPI can fall. Assuming the peak is 13.5% (current RPI), I computed the potential falls in percentage RPI in a 12-month period, by assuming a fall proportional to the selected 20 peaks. 

Apart from an outlier during the financial crisis in 2008 when you would have lost ~3.5%, every other case gives you a positive return. The average is 6.12% (remember these are worst case scenarios). However, I find 2008 to not be a relevant example given the RPI was much lower ~5%, but might be wrong here.

In conclusion, it seems that, unless very unlucky, this gilt will likely give you around 6% tax-free in a 12 month period, which beats savings accounts by far. Please let me know if you see any major flaw.

I have also questioned in my own mind how fast rpi can fall and how the breakeven inflation rate in those 24 gilts can be so low.  But I know nothing about inflation so have assumed the market does and has priced accordingly.  For example I have no idea what the wild swings in oil and gas prices will do to rpi in the next few months and whether the historic data you have looked at has such wild swings.