Nominal Gilt vs index linked Gilt

mr._prude

OldScientist great information, could you explain the last graph, is that all passive equity funds?

JohnWinder

Is the difference solely down to gilts duration?’

The yield to maturity on nominal bonds is a different value from the figure for same maturity linkers because of what inflation is expected to be. If investors are to get no inflation adjustment with nominal bonds, then they want some compensation in the form of higher yield; and the more they expect inflation to be the more yield over linkers’ yield do they demand.

Thus, if the market’s expectation of inflation changes significantly then the yield difference will change and as a consequence the price of those gilts with fixed yields (which is all of them, of both types, because the coupon % is stamped on the bond at issuance and it doesn’t change). So, no, probably not.

GazzaBloom

OldScientist said:

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)

Thanks, I guess it comes comes down to why you want to hold bonds/gilts in the first place. I just don't see holding a fund which is a bag full of debts particularly appealing, I would rather invest in companies that will grow, innovate, expand by selling a range of products and services.

I want stability and risk-off in opposition to equities so keep at the short end of the curve with either cash or MMF, I wouldn't hold bonds for growth, that's what the equities are for.

It seems to me that you need to keep abreast of expected inflation, interest rates and the yield curve to determine what duration to hold in bonds and when. The last couple of years shock to bonds has been an eye opener and I'm glad I wasn't invested in bonds.

Hoenir

Linton said:

 Now with interest rates at around 4-5% the market for IL gilts is much smaller.

Fairly illiquid market. Where the pension funds are long term holders and will continue to be so. 

Hoenir

mr._prude said:

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

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

The price of inflation linked Gilts reached such a level that they were forecast to produce a negative return. Such was the chase for safe investments and secure yields. The QE era created all sorts of anomalies. That over time will surface. Now that interest rates have normalised. Gilts due to their direct interaction with interest rates react instanteously. Much of the paper losses incurred will unwind as time passes. If the Gilts are held to maturity. 

mr._prude

My understanding is that bonds are a hedge against stock market crashes, and if I was planning on taking an annuity I should increase my bond ratio as I age.

At present I plan to go down the draw-down route,  so I am only keeping around 10-20% bond ratio. My thinking behind this is, if I''m at the draw-down stage and the stock market is growing I would draw-down from those equity funds. And when the stock market crashes I would draw-down from the bond funds until the it recovers.

MarkCarnage

mr._prude said:

My understanding is that bonds are a hedge against stock market crashes, and if I was planning on taking an annuity I should increase my bond ratio as I age.

At present I plan to go down the draw-down route,  so I am only keeping around 10-20% bond ratio. My thinking behind this is, if I''m at the draw-down stage and the stock market is growing I would draw-down from those equity funds. And when the stock market crashes I would draw-down from the bond funds until the it recovers.

Equity and bond correlations can be unstable too, hence the breakdown of the 60/40 balanced fund model. And corporate bonds and Government bonds such as gilts don't always behave the same either....such as 2008/9.
If planning on taking an annuity, longer duration gilts or a longer duration gilt fund is not a bad hedge on that. 
Your thinking on draw down is ok in principle, but there is a case for keeping the 'bonds' at short duration or in cash, if it's only to cover a couple of years drawdown requirements. Quite a lot of threads on this. 
For several years until recently, I saw little or no point in holding mainstream bonds at all in a portfolio, as QE had completely distorted markets from long term economic reality. Return free risk is another way of putting it.....however, with yields having risen significantly over the last 12-18 months there is a much stronger case now. 

MarkCarnage

Linton said:

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.

Agree with first paragraph....low coupon long dated so very long duration and very sensitive to rate moves. Linkers can be just as volatile as equities. 
Second paragraph....they used to deliver 2.5-3% real yields to maturity, i.e. in addition to inflation. The move in gilt yields in the last 10-15 years was significant downward move in real yields across both conventional and IL gilts to the point where they became significantly negative. Returns were only higher on linkers because of long duration, but that reversed very sharply as we know....
The market for linkers as others have commented is heavily dominated by institutions, mainly pension funds, who use them as hedges on inflation uncertainty for their inflation linked liabilities. They have often been price insensitive as the 'pain' of deficit volatility has outweighed price sensitivity. They will continue to be long term holders and use it as liability matching tool when held to maturity. 
The problem for individuals arises often when they mistakenly believe that they work like index linked NSCs! 
QE massively distorted this market too....the implied long term inflation rate was very sticky at around 2.5-3.5% for years. As it got higher, there was less incentive for pension funds with capped liabilities to hold IL bonds to the same extent but they remain very significant holders....indeed the IL gilt market wasn't big enough to support the appetite for holding them as hedges. 

Hoenir

mr._prude said:

My understanding is that bonds are a hedge against stock market crashes, and if I was planning on taking an annuity I should increase my bond ratio as I age.

Equities can be volatile in nature. Ultimately they reflect events in the real economy and underlying company fundamentals. Rather than being instruments of speculation driven by monetary momentum. When equities do peak and subsequently fall. Bonds historically have provided a positive return that offsets some of the negative return on equities. Markets can take some years to recover to former heights after a sharp sudden correction. While stats regarding long term performance are all very well. Timing of events could have a real impact on you personally. The only certainty when investing is uncertainty. No amount of hindsight can forecast tomorrow's events. 

michaels

To me the big question is why the real yield to maturity of index linked bonds shifted so much?  Have we suddenly become less risk averse so are no longer willing to pay a penalty for inflation protection?