Index linked gilt

nonolerigolo

I understand that for IL gilts trading slightly below par, it is an insurance against CPI/RPI. I am however looking at other potential risks with this products. 

For example, if deflation happens, does it mean that the money returned at maturity could be lower than what was invested initially. 

Is deflation common? I can see that this has happened in the 30’s. 

Any thoughts appreciated.Thank you 

JohnWinder

I understand that for IL gilts trading slightly below par, it is an insurance against CPI/RPI. I am however looking at other potential risks with this products. 

For example, if deflation happens, does it mean that the money returned at maturity could be lower than what was invested initially. 

Yes, the number of pounds could be lower. Would the purchasing power be lower? Don’t think so. I think there is no floor to the deflation adjusted value of linkers; some countries put a floor of ‘100’ to stop values falling below ‘face value’.

Here’s a recent history of UK annual inflation. Not common I’d say. https://www.inflationtool.com/rates/uk/historical 

Trading below par or not, they protect against inflation. They don’t protect your spending power against negative real yields (which you’ll know about the minute before you buy them), or against selling them when interest rates rise. Easily confused. 

More of your money comes back at redemption compared to nominal bonds, compared with trickling back as coupons, so I suppose they’re slightly riskier with default of the issuer.

Linton

Index linked gilts only guarantee to match RPI if you buy them at par (£100) and hold until maturity.  If you sell earlier the price can be volatile as we saw last year.  If you buy at less than par your returns at maturity will exceed inflation, if you buy at more than par they will be lower.

The redemption price will follow the RPI index so to actually lose money if you buy at par and hold until maturity is extremely unlikely since most index linked gilts are long-dated.  It is almost impossible for inflation to be negative over an extended period.

The guarantees only apply if you hold individual gilts.  If you hold a gilt fund the underlying gilts will behave as I have said but when you sell you would expect those underlying gilts to have a wide range of maturity dates.  You can never sell an index linked gilt fund with everything at maturity, hence it can be volatile depending on general interest rates. So you could lose money, especially if you only hold the fund for a short time.

JohnWinder

It might be easier to picture if it could be made clearer whether ‘par’ means £100, or the inflation adjusted value of £100, or both or neither. As well, whether ‘your returns (plural) at maturity’ means the money (singular) returned at maturity, or the total return of the investment which includes the principal and the coupons one receives (either at maturity, or all eligible coupons).

Linton

JohnWinder said:

It might be easier to picture if it could be made clearer whether ‘par’ means £100, or the inflation adjusted value of £100, or both or neither. As well, whether ‘your returns (plural) at maturity’ means the money (singular) returned at maturity, or the total return of the investment which includes the principal and the coupons one receives (either at maturity, or all eligible coupons).

In the UK the published price of all but the oldest index linked gilts ignores the inflation adjustment.  An IL gilt returns £100 X indexation factor on maturity.

I dont think this thread is the place to go into the complications of "clean" and "dirty" pricing.

All but the oldest IL gilts return very low interest so at the moment the coupon is a factor but not a major one compared with inflationary increases and potential price volatility if you are selling before maturity.