Index Linked Gilt ETF

JohnWinder

Does that mean, if we are speculating that the inflation will come down, the ETF currently is undervalued?

If you speculate Coca Cola will become everyone’s favourite drink next year and it happens, it is currently undervalued. If you speculate 500 iphones will explode next to users’ ears next year and it happens, it is currently over-valued. Speculating as a basis for investing isn’t a good strategy unless you’re going to be right more often than wrong, and the size of the ‘wrong’ bet losses aren’t bigger than the size of the ‘right’ bet wins. You don’t need to speculate to get investment market returns. 

‘No - as I understand things, inflation linked bonds that are far from maturity are priced on the expectations of long term inflation. ’

When you lend money and get a bond you get a promised-value coupon payment every promised period, and money back at the end to the value of the bond (£100 if it’s nominal, or £100 adjusted up or down for inflation/deflation over the life of the bond for a linker). 

By lending money you defer the gratification you get from spending, and so you want some return for that. You also know inflation will devalue your money when it’s returned to you with nominal bonds, so you want some extra return compensation for that. You also know that the bond issuer might default, so you want some compensation for that; you don’t get much with government bonds because the market view is that they’re unlikely to default. You also know that the longer the period until maturity of the bond, the more risk there is that interest rates will rise and you’ll be left holding a lower interest rate bond while new buyers will be getting higher interest paying bonds, so you want extra compensation for that.

Put it all together, and bonds have the risks of: inflation (not if they’re linkers though, as they get regular inflation adjustment to maturity price and coupon size); default; and interest rate or time to maturity risk. 

Whether linkers are far from maturity or close to maturity, the market guesses the inflation rate for the remaining life of the linker, and says: ‘if inflation will be zero, there’s no advantage or disadvantage to a linker over a nominal bond (of the same duration, from the same issuer etc), so we the market will set the yield (and thus price) for the linker as the same as for the nominal bond’. But if the market thinks there will be 2%/year inflation over this period, then the market will set the yield on the nominal bond as higher than for the linker, since the linker will get full compensation for the inflation, but the nominal bond won’t get any other than the extra coupon.

If linkers were the only bonds that ever existed, would they be priced on future inflation expectations? I can’t see why they would, since whatever the inflation turns out to be you get compensated for it. If there’s no (inflation) risk, why would there by a return (reflected in the price)?

Nominal bonds however are definitely priced on inflation expectations (amongst other factors: default, interest rate risk), whether they’re far from maturity or close to maturity.

OldScientist

JohnWinder said:

Because of their price volatility inflation linked bond index funds do not give great protection against inflation.

OK. So, better, worse or the same protection against inflation as nominal bond index funds? And just briefly, why.

Taking individual bonds for the moment:

According to tradeweb (12/7/2023 values), the nominal gilt maturing in July 2031 has a yield to maturity of about 4.5%.

The equivalent inflation linked gilt maturing in 2031 has a real ytm of 0.7%

This means that the market has currently priced in an 'implied inflation' (to use the Bank of England terminology rather than the US one of 'expected inflation') of 4.5-0.7=3.8%.

So, if annualised inflation between now and 2031 is higher than 3.8%, it would have been better to hold the inflation linked gilt, while if annualised inflation is lower than 3.8%, it would have been better to hold the nominal gilt*. Of course, it is not possible to know beforehand which of these outcomes will occur.

Broadly speaking, for two bond funds (one nominal and one inflation linked) with the same maturity the story will be similar. However, one of the problems with the standard passive UK linker fund is that the modified duration (i.e., a measure of the sensitivity to interest rate changes) is long (~16 years) compared to that of the equivalent nominal fund (~10 years) (e.g., see Vanguard Government Bond Index Fund and Inflation-Linked Gilt Index Fund).

* There are some small wrinkles here over coupon reinvestment that can probably be ignored for the moment.

Linton

OldScientist said:

JohnWinder said:

Because of their price volatility inflation linked bond index funds do not give great protection against inflation.

OK. So, better, worse or the same protection against inflation as nominal bond index funds? And just briefly, why.

Taking individual bonds for the moment:

According to tradeweb (12/7/2023 values), the nominal gilt maturing in July 2031 has a yield to maturity of about 4.5%.

The equivalent inflation linked gilt maturing in 2031 has a real ytm of 0.7%

This means that the market has currently priced in an 'implied inflation' (to use the Bank of England terminology rather than the US one of 'expected inflation') of 4.5-0.7=3.8%.

So, if annualised inflation between now and 2031 is higher than 3.8%, it would have been better to hold the inflation linked gilt, while if annualised inflation is lower than 3.8%, it would have been better to hold the nominal gilt*. Of course, it is not possible to know beforehand which of these outcomes will occur.

Broadly speaking, for two bond funds (one nominal and one inflation linked) with the same maturity the story will be similar. However, one of the problems with the standard passive UK linker fund is that the modified duration (i.e., a measure of the sensitivity to interest rate changes) is long (~16 years) compared to that of the equivalent nominal fund (~10 years) (e.g., see Vanguard Government Bond Index Fund and Inflation-Linked Gilt Index Fund).

* There are some small wrinkles here over coupon reinvestment that can probably be ignored for the moment.

I would be very grateful for any info on how to get ytm data.  I looked on  tradeweb.com but did not see any actual data. There used to be a free to access website (Fixedrateinvestor.co.uk or something like that) which provided a lot of useful bond info but it disappeared.

coyrls

Linton said:

OldScientist said:

JohnWinder said:

Because of their price volatility inflation linked bond index funds do not give great protection against inflation.

OK. So, better, worse or the same protection against inflation as nominal bond index funds? And just briefly, why.

Taking individual bonds for the moment:

According to tradeweb (12/7/2023 values), the nominal gilt maturing in July 2031 has a yield to maturity of about 4.5%.

The equivalent inflation linked gilt maturing in 2031 has a real ytm of 0.7%

This means that the market has currently priced in an 'implied inflation' (to use the Bank of England terminology rather than the US one of 'expected inflation') of 4.5-0.7=3.8%.

So, if annualised inflation between now and 2031 is higher than 3.8%, it would have been better to hold the inflation linked gilt, while if annualised inflation is lower than 3.8%, it would have been better to hold the nominal gilt*. Of course, it is not possible to know beforehand which of these outcomes will occur.

Broadly speaking, for two bond funds (one nominal and one inflation linked) with the same maturity the story will be similar. However, one of the problems with the standard passive UK linker fund is that the modified duration (i.e., a measure of the sensitivity to interest rate changes) is long (~16 years) compared to that of the equivalent nominal fund (~10 years) (e.g., see Vanguard Government Bond Index Fund and Inflation-Linked Gilt Index Fund).

* There are some small wrinkles here over coupon reinvestment that can probably be ignored for the moment.

I would be very grateful for any info on how to get ytm data.  I looked on  tradeweb.com but did not see any actual data. There used to be a free to access website (Fixedrateinvestor.co.uk or something like that) which provided a lot of useful bond info but it disappeared.

I have probably got this wrong but isn't the YTM (minus inflation) for an index linked gilt shown in the "Yield" column on Tradeweb?

OldScientist

YTM data:

Tradeweb: https://reports.tradeweb.com/closing-prices/gilts/ (always a day or two out of date though - not so important when prices/yields aren't changing too quickly)

General data (not specific to individual bonds, but are calculated from actual bond prices) from BoE (https://www.bankofengland.co.uk/statistics/yield-curves , the graphs are forward curves (which is not the same as yield to maturity), so download 'latest yield curve data' and look for the tab named 'spot curve'). Again values are from a day or two ago (they get updated around midday).

There is the option of using the yield function in excel/libreoffice etc. There is a nice tutorial towards the bottom of  http://www.tvmcalcs.com/calculators/apps/excel_bond_yields (although a google search will find others). In which case, you can enter live prices from the london stock exchange (e.g., https://www.londonstockexchange.com/live-markets/market-data-dashboard/price-explorer?categories=BONDS&subcategories=14 ). However, definitely worth testing this last option on known data beforehand (it, eventually after a bit of playing around, gave me the same answer as the tradeweb site).

coyrls

On a related matter, I haven't found any portfolio tracking site that allows you to add individual gilts to a portfolio.  Does anybody know of one that does allow gilts to be added?

aroominyork

coyrls said:

On a related matter, I haven't found any portfolio tracking site that allows you to add individual gilts to a portfolio.  Does anybody know of one that does allow gilts to be added?

HL allows it