Nominal Gilt vs index linked Gilt

mr._prude

Can anyone explain why index linked gilts dropped about 35% while nominal gilts dropped about 20%, last year?

My understanding was an indexed linked gilt was supposed to protect against inflation.

JohnWinder

That’s a correct understanding, they do. But remember, or newly, the price of bonds reflects bonds’ two main risks: the risk that interest rates change, and the risk that credit rating changes.

If interest rates rise it causes the price of existing bonds to fall (because they’re less attractive than soon to be issued higher interest rate paying bonds). That price fall can overwhelm and value increase which is a consequence of the inflation adjustment upward to the price.

The further the bond is away from maturity, the longer you are stuck with a lower paying bond when interest rates rise, therefore the further their price falls.

Your first sentence depicts several scenarios, but if the above explains it for you don’t bother elaborating on your first sentence to make it clearer with examples of bonds we might look at.

A more sensible term for ‘gilts’ which are not index linked gilts is ‘nominal gilts’, because if index linked gilts are gilts then what are ‘gilts’? Just as there’s a better way to say ‘black cats give me a creepy feeling the way cats don’t’?

GazzaBloom

The more I learn about bonds, bond funds and gilts, the less appealing they become in my eyes for a buy and hold set and forget portfolio.

The closest I have come to buying bonds is a short term money market fund where the duration is measured in days.

Linton

The main reason index linked gilts fell so much was that many of them are a long way from maturity so any change to interest rates is compounded over decades.

The reason that they fill at all was that they can be seen as returning 2.5%-3% over their lifetime, that being the expected long term inflation. When  fixed gilt interest  rates were <1% index linked gilts were attractive simply because their returns were much higher. Now with interest rates at around 4-5% the market for IL gilts is much smaller.

Pat38493

Would an idiot's explanation of this be - nobody wants to buy second hand bonds with very low coupon (interest) values when they could buy new ones with much higher interest?

OldScientist

mr._prude said:

Can anyone explain why index linked gilts dropped about 30% while gilts dropped about 15%?

My understanding was an indexed linked gilt was supposed to protect against inflation.

Do you mean gilt funds or individual gilts? And since when?

If gilts funds, then the difference between the 'all stocks' nominal gilt funds (e.g., iShares UK Gilts All Stocks Index Fund) and the equivalent index linked gilt fund (e.g., iShares Index Linked Gilt Index Fund) is duration (which is a measure of the time to maturity of the bonds inside the fund ad a measure of the interest rate sensitivity of the fund). The nominal gilt fund currently has a duration of about 8 years and the index linked fund has one of 18 years. The rule of thumb is that for every percentage point change in bond yields, the fund NAV will change by an amount equal to the duration. In other words, since yields have gone up by about 3 percentage points since the start of 2022, then you'd expect a decrease in NAV of about 24% for nominals and 54% for index linked over the same period (this is ignoring the fact that the increase in yields occurred over an extended period of time rather than suddenly).

The price changes for individual gilts of the same duration of either type have followed each other, more or less.

mr._prude

Thanks for the replies, yes I should have referenced the funds I was thinking of. I have added them below and corrected the OP.

Normal Gilt fund

https://www.trustnet.com/factsheets/p/gs3d/aviva-pen-gilt-pn-s14

Discrete performance -7.2% (0-12m) -19.5% (12-24m) -3.2% (24-36m)

Index linked Gilt fund

https://www.trustnet.com/factsheets/p/erp5/aviva-pen-index-linked-gilt-pn-s3

Discrete performance -15.8% (0-12m) -35.1% (12-24m) 7.4% (24-36m)

Is the difference solely down to gilts duration?

OldScientist

GazzaBloom said:

The more I learn about bonds, bond funds and gilts, the less appealing they become in my eyes for a buy and hold set and forget portfolio.

The closest I have come to buying bonds is a short term money market fund where the duration is measured in days.

While I agree with you to a large extent (a significant amount of our 'fixed income' is currently in money market funds and 1 year fixed rate savings accounts, while the much of the rest is in a short term ladder), there is a compromise between longer duration bonds that have typically has greater returns, but larger price volatility, and short term bonds (or bills) that have typically have had lower returns but lower price volatility.

The following graph shows the total return growth (i.e., including coupon reinvestment) of various gilt maturities since 1998 (note, that as far as I am aware, only 0-5 years, 15+ years, and all stocks are available as passive funds to invest in - does anyone know any different?). In the somewhat unusual bond bull market that has now most definitely ended, anyone investing in the longest duration fund (15+ years) would have seen a peak of 4 times their investment, before it fell to twice the initial investment in the last year or so. Coincidentally, the current value of the 15+ sector is about the same as 'all stocks' and '0 to 5 years'. However, the intermediate maturities (5-10, 10-15, and 5-15 years) are all slightly higher at around the 250% mark.  Of course, people don't usually invest a lump sum in that way.



Data from The Heriot-Watt University/Institute and Faculty of Actuaries, British Government Securities Database (although I've normalised the indices for each maturity to be 100 in 1998)

JohnWinder

The reason that (linkers) fill (fell, I think) at all was that they can be seen as returning 2.5%-3% over their lifetime, that being the expected long term inflation. When  fixed gilt interest  rates were <1% index linked gilts were attractive simply because their returns were much higher.’

Calculating a return of 2.5% (per year) over a lifetime for a linker is calculating the real (after inflation) return. To estimate the linker’s nominal return would need you to guess the inflation over that period; people don’t do that normally, so linker return is real return. As a consequence, if the linker real return was to be 2.5% (all % are per year for this discussion), then the nominal return would be 5% if inflation turned out to be 2.5% (or 8% if inflation turned out to be 5.5%).

And so to nominal bonds: when nominal ‘gilt interest rates were <1%’ their owners were getting a nominal return of <1% while linker owners were getting 5% or 8%. Would you rather earn <1% whatever inflation was, or 2.5% above whatever inflation was?
Clearly the latter, and while ever any such imbalance arises investors will move their money to get the better deal until both deals remain equal and there is no imbalance. If linkers were so attractive investors would have poured into them pushing up the price, not down.

Perhaps I’ve misunderstood the quoted statement as I can do. Welcome any clarification.

Would an idiot's explanation of this be - nobody wants to buy second hand bonds with very low coupon (interest) values when they could buy new ones with much higher interest?

Pretty much, but you could add 'price' to make it even clearer for people struggling with bonds.

'nobody wants to buy (at a certain price) second hand bonds with very low coupon (interest) values when they could buy new ones with much higher interest (at the same price)'.  The nobodies will buy the second hand bonds at a lower price which is how the price gets set.

zagfles

mr._prude said:

Thanks for the replies, yes I should have referenced the funds I was thinking of. I have added them below and corrected the OP.

Normal Gilt fund

https://www.trustnet.com/factsheets/p/gs3d/aviva-pen-gilt-pn-s14

Discrete performance -7.2% (0-12m) -19.5% (12-24m) -3.2% (24-36m)

Index linked Gilt fund

https://www.trustnet.com/factsheets/p/erp5/aviva-pen-index-linked-gilt-pn-s3

Discrete performance -15.8% (0-12m) -35.1% (12-24m) 7.4% (24-36m)

Is the difference solely down to gilts duration?

From a quick glance it does look like the IL fund has longer duration bonds and that'll make a big difference. It also has a high AMC for a gilts funds, 1% compared to 0.1% for the flat gilts fund.

But the question is why do you care? Unless you're speculating, the usual reason to buy gilt funds is if you're planning to buy an annuity. If gilts go down, annuity rates should go up. 

Individual IL gilts can be used to guarantee a real rate of return up to maturity.

zagfles

Pat38493 said:

Would an idiot's explanation of this be - nobody wants to buy second hand bonds with very low coupon (interest) values when they could buy new ones with much higher interest?

Because the market price of low coupon gilts will be lower than the market price of high coupon gilts with the same duration. So generally what you lose in interest you make up for with capital gain.

If you buy individual gilts unwrapped, many people prefer a capital gain to interest, since the interest is taxable but the capital gain isn't.