Nominal Gilt vs index linked Gilt

Hoenir

michaels said:

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?

BOE was underpinning the entire Gilts market driving the yield curve downwards. Now we've entered a new era of Quantitative Tightening.  For over a year now the BOE has been selling around £8 billion a month of Gilts and Corporate Bonds ( no CB's now remain on the BOE's balance sheet) back into the markets. Likewise there's been no reinvestment of maturity proceeds or interest received.  The BOE was the first Central Bank to adopt the QT policy and is the most aggressive in terms of balance sheet run-off. 

The markets have to absorb not only the stock that's been sold back into the markets but also the new issuance and refinancing. At what point will indigestion be reached? Over the pond already early signs of cracks. Higher for longer appears to provide some interesting  investment connotations. 

Linton

michaels said:

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?

The YTM includes both the interest and the real capital loss/gain at maturity based on buying at the then current price. It does not include inflation. Before the fall in interest rates when prices were very high there would have been a capital loss relative to inflation at maturity.  On the other hand since the unit price is now much lower the effective interest rate is higher.

michaels

Linton said:

michaels said:

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?

The YTM includes both the interest and the real capital loss/gain at maturity based on buying at the then current price. It does not include inflation. Before the fall in interest rates when prices were very high there would have been a capital loss relative to inflation at maturity.  On the other hand since the unit price is now much lower the effective interest rate is higher.

Sorry, I meant the real effective yield if held to maturity, it was negative by a percent or two and is now positive by about 0.5%.  I guess as Hoenir suggests,  this reflects a general shift in the demand/supply balance for bonds overall.

Hoenir

michaels said:

Linton said:

michaels said:

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?

The YTM includes both the interest and the real capital loss/gain at maturity based on buying at the then current price. It does not include inflation. Before the fall in interest rates when prices were very high there would have been a capital loss relative to inflation at maturity.  On the other hand since the unit price is now much lower the effective interest rate is higher.

Sorry, I meant the real effective yield if held to maturity, it was negative by a percent or two and is now positive by about 0.5%.  I guess as Hoenir suggests,  this reflects a general shift in the demand/supply balance for bonds overall.

What the BOE currently holds in the way of Gilts can be found on here. As far as ILG's are concerned it's now zero. 

https://www.yieldgimp.com/gilt-yields

OldScientist

mr._prude said:

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

Yes, effectively those are for passive indexes rather than actual funds (i.e., the returns don't include the effect of fees)

OldScientist

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?

While these don't appear to be entirely passive funds (although I could be wrong), looking at the duration the nominal one currently has a much shorter duration (only 27% of the fund has a maturity greater than 15 years) than the index linked one (where 58% of the fund has a maturity greater than 15 years) and therefore for the same change in yield would have undergone a larger change in value.

Since the beginning of 2021, nominal yields have increased by about 4.3 percentage points (it depends on the maturity, but the spot yields on 10 year bonds have increased from 0.23% to 4.51% to end of October 2023), while the real spot yields on inflation linked gilts (10 year maturity) have increased from -2.98% to 0.95%, i.e. about 3.8 percentage points. In other words, the changes in yields are fairly close to each other and, therefore, I do think the difference in performance of the two funds is largely down to duration of the funds.

OldScientist

GazzaBloom said:

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.

Since I'm retired and using a dynamic withdrawal method, for me the fixed income is there to reduce the volatility of the overall portfolio - since we were holding quite a lot of short duration stuff (cash!), then it did a reasonable job. Had I been holding a 15+ year gilt fund, it wouldn't have been pretty. Holding gilts (or gilt funds) for their coupon payments is another approach and one that is more attractive now that nominal yields (and coupons for newly issued gilts) are at 4% or so than it would have been 3 or so years ago.

For someone still in accumulation, there is probably little reason to hold more than 10-20% in bonds (if that, although emergency cash is a different matter), although the long timescales involved might suggest longer durations.

For a passive investor, the usual advice (from the US - e.g. see Bogleheads) is that for retirees, intermediate duration bonds (i.e., maturities of around 5 to 10 years) form a reasonable compromise between returns and volatility - it is unfortunate that a 5-10 year index fund in UK nominal gilts doesn't appear to be available - an approximation can be constructed by combining an 'all stocks' and a 0-5 fund (or indeed MMF).

I;d agree that it has certainly has been a bit of a shock though - the last couple of years represent some of the worst bond performances in history (and UK bonds go back more than 200 years).

All interesting, but probably getting a bit far from the OP...

Hoenir

OldScientist said:

For a passive investor, the usual advice (from the US - e.g. see Bogleheads) is that for retirees, intermediate duration bonds (i.e., maturities of around 5 to 10 years) form a reasonable compromise between returns and volatility - it is unfortunate that a 5-10 year index fund in UK nominal gilts doesn't appear to be available 

That's the inherent danger when reading US websites. How the US and UK finance themselves is somewhat different at the Treasury level. The US issues a considerable amount of short to medium term Treasury Bills (as distinct from bonds) with a duration of 2-10 years. In addition US investors have access to other bond instruments such as municipal besides corporate bonds . Taken as a whole the US bond markets encompass over 10,000 stocks. A wide universe in which to pick stocks to create investment vehicles. 

Apologies to the OP. As somewhat off topic ! 

Personally I'd be inclined to park the July 2007 to early 2023 period. While interesting as it is to nerds such as myself. The era has now past. There's been a major reset. One needs to look forward and make decisions as matters stand today and as events unfold. There's no handbook for exiting Quantitative Easing.  Going to be no shortage of shocks and surprises. 

OldScientist

Hoenir said:

OldScientist said:

For a passive investor, the usual advice (from the US - e.g. see Bogleheads) is that for retirees, intermediate duration bonds (i.e., maturities of around 5 to 10 years) form a reasonable compromise between returns and volatility - it is unfortunate that a 5-10 year index fund in UK nominal gilts doesn't appear to be available 

That's the inherent danger when reading US websites. How the US and UK finance themselves is somewhat different at the Treasury level. The US issues a considerable amount of short to medium term Treasury Bills (as distinct from bonds) with a duration of 2-10 years. In addition US investors have access to other bond instruments such as municipal besides corporate bonds . Taken as a whole the US bond markets encompass over 10,000 stocks. A wide universe in which to pick stocks to create investment vehicles. 

Apologies to the OP. As somewhat off topic ! 

Personally I'd be inclined to park the July 2007 to early 2023 period. While interesting as it is to nerds such as myself. The era has now past. There's been a major reset. One needs to look forward and make decisions as matters stand today and as events unfold. There's no handbook for exiting Quantitative Easing.  Going to be no shortage of shocks and surprises. 

Overall, the maturity profile for the UK is much longer than the US for both nominal and inflation linked bonds (for a start the US limits bonds (or notes for those with maturities 1 to 10 years) to a maximum of 30 years, whereas the UK government has issued bonds out to beyond 2070) which means that a UK passive fund following an index that incorporates all available bonds will be far more sensitive to interest rates than the equivalent US ones. FTSE-Russell actually have an index for gilts with up to 10 year maturities, but (as far as I know) there are no actual funds following it. Edit: ishares have one https://www.ishares.com/uk/individual/en/products/331740/ishares-up-to-10-years-gilts-index-fund-uk that is very new (June 2023).

I'm not sure the future for bonds is so different from periods in the past. Yields might go up further (in which case bond fund prices will drop), they might stabilise and stay similar to what they already are (in which case bond fund prices will creep up at about 4% per year as coupons are reinvested and the maturity of existing bonds decreases) or yields may go down (in which case bond fund prices will increase). There are probably people willing and able to make a convincing case for any of those outcomes!

MarkCarnage

Gilt market issuance has been heavily influenced by end user demand....pension funds and increasingly insurance companies have sought long dated issuance in both conventionals and linkers to assist in liability matching. That process continues, though over time ultra long may be less needed as DB pensions mature. 
On the future v the past, I'm with @Hoenir in not placing too much weight on the 2008-22 period which was driven very heavily by QE. From 1981-2007 the bull market in bonds was driven by a disinflationary environment linked to globalisation, QE drove the second part to 2021 and was an artifice. I suspect we will see a more volatile environment with a bias to inflationary spikes in coming years. Bonds do look more fairly priced than they did 2 or 3 years ago when return free risk sprang to mind as the best way to describe them.