The bond/gilt market

MK62

masonic said:

MK62 said:

The problem with trying to include inflation in the "risk free rate" is that you have no idea what inflation will be.
At the typical individual investor level, I'm not sure it matters either tbh.
If you consider someone with say £10k sitting in a current account or in a safe at home, then to him/her, the risk free rate is going to be the return rate obtainable over the timeframe in question, with no risk to capital (barring armageddon events, as Linton suggests). For short timeframes, that's probably going to be bank/BS deposit accounts........for longer timeframes, gilts are really the only option.......but in any case the inflation risk is the same, and hence cancels out.
The "real" return that investor will get is unknowable........and the longer the timeframe, the more unknowable it becomes. Fair enough though, just because, it cancels out between the two options, doesn't mean it goes away.......inflation risk remains, it's just not quantifiable (not without guessing anyway).
Perhaps it should be called "nominal risk free rate", to make it more apparent that it doesn't account for inflation......

Complicated by the fact that index linked investments exist, so whether or not you know what inflation will be, you can buy an investment with a known real rate of return. You can look at the difference between comparable nominal and inflation linked investments to determine the market's implied future inflation rate, but if you invest what you will get is the actual inflation rate as determined by the index used. So you don't need to know the inflation rate to protect your capital from inflation risk, providing you trust the inflation index.

This may not always be true though........I guess caveat emptor applies here.......certainly index linked gilt funds haven't protected your capital from inflation risk......

masonic

MK62 said:

masonic said:

MK62 said:

The problem with trying to include inflation in the "risk free rate" is that you have no idea what inflation will be.
At the typical individual investor level, I'm not sure it matters either tbh.
If you consider someone with say £10k sitting in a current account or in a safe at home, then to him/her, the risk free rate is going to be the return rate obtainable over the timeframe in question, with no risk to capital (barring armageddon events, as Linton suggests). For short timeframes, that's probably going to be bank/BS deposit accounts........for longer timeframes, gilts are really the only option.......but in any case the inflation risk is the same, and hence cancels out.
The "real" return that investor will get is unknowable........and the longer the timeframe, the more unknowable it becomes. Fair enough though, just because, it cancels out between the two options, doesn't mean it goes away.......inflation risk remains, it's just not quantifiable (not without guessing anyway).
Perhaps it should be called "nominal risk free rate", to make it more apparent that it doesn't account for inflation......

Complicated by the fact that index linked investments exist, so whether or not you know what inflation will be, you can buy an investment with a known real rate of return. You can look at the difference between comparable nominal and inflation linked investments to determine the market's implied future inflation rate, but if you invest what you will get is the actual inflation rate as determined by the index used. So you don't need to know the inflation rate to protect your capital from inflation risk, providing you trust the inflation index.

This may not always be true though........I guess caveat emptor applies here.......certainly index linked gilt funds haven't protected your capital from inflation risk......

It is only true when you purchase individual index linked gilts and hold them to maturity. If you are a gilt trader, which someone holding a gilt fund necessarily is, then you are exposed to market volatility. The only way to get any of your capital back from a fund is to sell units. When you sell units in your fund you are forced to sell a whole portfolio of gilts at their current market price.

MK62

masonic said:

MK62 said:

masonic said:

MK62 said:

The problem with trying to include inflation in the "risk free rate" is that you have no idea what inflation will be.
At the typical individual investor level, I'm not sure it matters either tbh.
If you consider someone with say £10k sitting in a current account or in a safe at home, then to him/her, the risk free rate is going to be the return rate obtainable over the timeframe in question, with no risk to capital (barring armageddon events, as Linton suggests). For short timeframes, that's probably going to be bank/BS deposit accounts........for longer timeframes, gilts are really the only option.......but in any case the inflation risk is the same, and hence cancels out.
The "real" return that investor will get is unknowable........and the longer the timeframe, the more unknowable it becomes. Fair enough though, just because, it cancels out between the two options, doesn't mean it goes away.......inflation risk remains, it's just not quantifiable (not without guessing anyway).
Perhaps it should be called "nominal risk free rate", to make it more apparent that it doesn't account for inflation......

Complicated by the fact that index linked investments exist, so whether or not you know what inflation will be, you can buy an investment with a known real rate of return. You can look at the difference between comparable nominal and inflation linked investments to determine the market's implied future inflation rate, but if you invest what you will get is the actual inflation rate as determined by the index used. So you don't need to know the inflation rate to protect your capital from inflation risk, providing you trust the inflation index.

This may not always be true though........I guess caveat emptor applies here.......certainly index linked gilt funds haven't protected your capital from inflation risk......

It is only true when you purchase individual index linked gilts and hold them to maturity. If you are a gilt trader, which someone holding a gilt fund necessarily is, then you are exposed to market volatility. The only way to get any of your capital back from a fund is to sell units. When you sell units in your fund you are forced to sell a whole portfolio of gilts at their current market price.

I understand that.....it's why I mentioned them.....but you stated "index linked investments exist", and some might think that moniker would include index-linked gilt funds/ETFs.....I just wanted to clarify that it might not, and "index-linked" in the name of an investment may not mean what some might think it means....

As for individual index linked gilts held to maturity protecting your capital against inflation risk......it's true at the moment, but is that always the case?

masonic

MK62 said:

As for individual index linked gilts held to maturity protecting your capital against inflation risk......it's true at the moment, but is that always the case?

It's true when the inflation index goes up at least as much as your personal inflation rate. It may not be true at the moment for some people as some are feeling the effects of inflation at 30%+, but over a longer timescale is more likely to average out. People feel the effects of inflation at different times, so one needs to look over the long term. When CPIH takes over from RPI in 2030, then there will be less margin in the index for those with higher personal inflation rates, but in my experience RPI has been much higher than my personal inflation rate. The solution to a higher than average personal inflation rate is probably not a financial instrument. There is also the consideration of indexation lag that can cause discrepancies over short periods as I brought up a few pages ago.

zagfles

MK62 said:

masonic said:

MK62 said:

masonic said:

MK62 said:

The problem with trying to include inflation in the "risk free rate" is that you have no idea what inflation will be.
At the typical individual investor level, I'm not sure it matters either tbh.
If you consider someone with say £10k sitting in a current account or in a safe at home, then to him/her, the risk free rate is going to be the return rate obtainable over the timeframe in question, with no risk to capital (barring armageddon events, as Linton suggests). For short timeframes, that's probably going to be bank/BS deposit accounts........for longer timeframes, gilts are really the only option.......but in any case the inflation risk is the same, and hence cancels out.
The "real" return that investor will get is unknowable........and the longer the timeframe, the more unknowable it becomes. Fair enough though, just because, it cancels out between the two options, doesn't mean it goes away.......inflation risk remains, it's just not quantifiable (not without guessing anyway).
Perhaps it should be called "nominal risk free rate", to make it more apparent that it doesn't account for inflation......

Complicated by the fact that index linked investments exist, so whether or not you know what inflation will be, you can buy an investment with a known real rate of return. You can look at the difference between comparable nominal and inflation linked investments to determine the market's implied future inflation rate, but if you invest what you will get is the actual inflation rate as determined by the index used. So you don't need to know the inflation rate to protect your capital from inflation risk, providing you trust the inflation index.

This may not always be true though........I guess caveat emptor applies here.......certainly index linked gilt funds haven't protected your capital from inflation risk......

It is only true when you purchase individual index linked gilts and hold them to maturity. If you are a gilt trader, which someone holding a gilt fund necessarily is, then you are exposed to market volatility. The only way to get any of your capital back from a fund is to sell units. When you sell units in your fund you are forced to sell a whole portfolio of gilts at their current market price.

I understand that.....it's why I mentioned them.....but you stated "index linked investments exist", and some might think that moniker would include index-linked gilt funds/ETFs.....I just wanted to clarify that it might not, and "index-linked" in the name of an investment may not mean what some might think it means....

As for individual index linked gilts held to maturity protecting your capital against inflation risk......it's true at the moment, but is that always the case?

Although IL gilt funds will be subject to the whims of the market and are certainly not "risk free", they will at least provide a hedge against inflation. Their main use is probably for those who intend buying an IL annuity - as annuity rates will generally rise as IL gilt prices fall and vv.

Individual IL gilts held to maturity will protect capital against inflation risk subject to the caveats mentioned above about personal inflation, index lag, and of course the risk of govt default. I say inflation "risk", but if for instance the market price is over par as it was until a few years ago, that could be a guaranteed real capital loss (so not "risk", it's known). These days it's mostly a guaranteed real capital gain.

Linton

MK62 said:

masonic said:

MK62 said:

masonic said:

MK62 said:

The problem with trying to include inflation in the "risk free rate" is that you have no idea what inflation will be.
At the typical individual investor level, I'm not sure it matters either tbh.
If you consider someone with say £10k sitting in a current account or in a safe at home, then to him/her, the risk free rate is going to be the return rate obtainable over the timeframe in question, with no risk to capital (barring armageddon events, as Linton suggests). For short timeframes, that's probably going to be bank/BS deposit accounts........for longer timeframes, gilts are really the only option.......but in any case the inflation risk is the same, and hence cancels out.
The "real" return that investor will get is unknowable........and the longer the timeframe, the more unknowable it becomes. Fair enough though, just because, it cancels out between the two options, doesn't mean it goes away.......inflation risk remains, it's just not quantifiable (not without guessing anyway).
Perhaps it should be called "nominal risk free rate", to make it more apparent that it doesn't account for inflation......

Complicated by the fact that index linked investments exist, so whether or not you know what inflation will be, you can buy an investment with a known real rate of return. You can look at the difference between comparable nominal and inflation linked investments to determine the market's implied future inflation rate, but if you invest what you will get is the actual inflation rate as determined by the index used. So you don't need to know the inflation rate to protect your capital from inflation risk, providing you trust the inflation index.

This may not always be true though........I guess caveat emptor applies here.......certainly index linked gilt funds haven't protected your capital from inflation risk......

It is only true when you purchase individual index linked gilts and hold them to maturity. If you are a gilt trader, which someone holding a gilt fund necessarily is, then you are exposed to market volatility. The only way to get any of your capital back from a fund is to sell units. When you sell units in your fund you are forced to sell a whole portfolio of gilts at their current market price.

I understand that.....it's why I mentioned them.....but you stated "index linked investments exist", and some might think that moniker would include index-linked gilt funds/ETFs.....I just wanted to clarify that it might not, and "index-linked" in the name of an investment may not mean what some might think it means....

As for individual index linked gilts held to maturity protecting your capital against inflation risk......it's true at the moment, but is that always the case?

Ignoring the interest and any charges, index linked gilts only match inflation if you  sell at the same clean price as you bought. 

Consider:
Working in terms of clean price and ignoring interest and charges: If you buy  £130K worth when the clean price is at £130 You will get 1000 bonds each with a face value of £100.  If you sell at par after 10 years (£100)  when prices have risen 30%, equivalent to average annual inflation of 2.66%,  you will receive a lump sum of 1000 X100 X  (1+0.3) =£130K, so no inflation matching at all.

From my example you may think that you could make a capital loss in £ terms **.  However the pricing calculation ensures that if inflation over the same duration  matches the market's expectations you will get a similar return to the then current market interest rates for the same duration. For practical purposes these will certainly be positive.

Right now clean IL gilt prices are close to or below par so should be a good bet if you want protection against unexpectedly high inflation and wont need to cash-in in an emergency..



** edit - if you hold to matutity

Mikeeee_2

Linton said:

MK62 said:

masonic said:

MK62 said:

masonic said:

MK62 said:

The problem with trying to include inflation in the "risk free rate" is that you have no idea what inflation will be.
At the typical individual investor level, I'm not sure it matters either tbh.
If you consider someone with say £10k sitting in a current account or in a safe at home, then to him/her, the risk free rate is going to be the return rate obtainable over the timeframe in question, with no risk to capital (barring armageddon events, as Linton suggests). For short timeframes, that's probably going to be bank/BS deposit accounts........for longer timeframes, gilts are really the only option.......but in any case the inflation risk is the same, and hence cancels out.
The "real" return that investor will get is unknowable........and the longer the timeframe, the more unknowable it becomes. Fair enough though, just because, it cancels out between the two options, doesn't mean it goes away.......inflation risk remains, it's just not quantifiable (not without guessing anyway).
Perhaps it should be called "nominal risk free rate", to make it more apparent that it doesn't account for inflation......

Complicated by the fact that index linked investments exist, so whether or not you know what inflation will be, you can buy an investment with a known real rate of return. You can look at the difference between comparable nominal and inflation linked investments to determine the market's implied future inflation rate, but if you invest what you will get is the actual inflation rate as determined by the index used. So you don't need to know the inflation rate to protect your capital from inflation risk, providing you trust the inflation index.

This may not always be true though........I guess caveat emptor applies here.......certainly index linked gilt funds haven't protected your capital from inflation risk......

It is only true when you purchase individual index linked gilts and hold them to maturity. If you are a gilt trader, which someone holding a gilt fund necessarily is, then you are exposed to market volatility. The only way to get any of your capital back from a fund is to sell units. When you sell units in your fund you are forced to sell a whole portfolio of gilts at their current market price.

I understand that.....it's why I mentioned them.....but you stated "index linked investments exist", and some might think that moniker would include index-linked gilt funds/ETFs.....I just wanted to clarify that it might not, and "index-linked" in the name of an investment may not mean what some might think it means....

As for individual index linked gilts held to maturity protecting your capital against inflation risk......it's true at the moment, but is that always the case?

Ignoring the interest and any charges, index linked gilts only match inflation if you  sell at the same clean price as you bought. 

Consider:
Working in terms of clean price and ignoring interest and charges: If you buy  £130K worth when the clean price is at £130 You will get 1000 bonds each with a face value of £100.  If you sell at par after 10 years (£100)  when prices have risen 30%, equivalent to average annual inflation of 2.66%,  you will receive a lump sum of 1000 X100 X  (1+0.3) =£130K, so no inflation matching at all.

From my example you may think that you could make a capital loss in £ terms **.  However the pricing calculation ensures that if inflation over the same duration  matches the market's expectations you will get a similar return to the then current market interest rates for the same duration. For practical purposes these will certainly be positive.

Right now clean IL gilt prices are close to or below par so should be a good bet if you want protection against unexpectedly high inflation and wont need to cash-in in an emergency..



** edit - if you hold to matutity

This is exactly why I bought an IL gilt at £92. I can't really lose.

MK62

Depends what you call "lose" really.
If inflation runs lower than the breakeven rate on the date you bought your IL gilt, the total return will be less than you'd have got back if you'd bought a similar dated conventional gilt instead.......the flip side obviously being that if inflation runs higher, you'd get back more with the IL gilt......hence Linton's comment about protection from higher than expected inflation.

Mikeeee_2

MK62 said:

Depends what you call "lose" really.
If inflation runs lower than the breakeven rate on the date you bought your IL gilt, the total return will be less than you'd have got back if you'd bought a similar dated conventional gilt instead.......the flip side obviously being that if inflation runs higher, you'd get back more with the IL gilt......hence Linton's comment about protection from higher than expected inflation.

Well I bought them about a year ago and that was a risk I'm certainly (still) ok with given the RPI rate they're linked to!