Trying to get my head around inflation linked gilts

Granddadofyear

If my view is that inflation is going to drop significantly over the next 2 years - let’s say back to the BOE 2% target

I’ve been told to buy long duration investment linked gilts…

It sounds counter intuitive as you would usually buy IL gilts to protect against inflation rising right?

But this wouldn’t be to buy and hold until maturity, but to buy and sell over a 2 year investment horizon.

Because as inflation drops, the coupon paid on the IL bonds drop which causes the cash price to increase.

Does this sound too simple? I’m sure it’s more complicated than that. I am reading the material on the DMO site but thought I would post here for any help.

OldScientist

If the yields on inflation linked gilts (ILG) drop then the prices will go up.

Taking the longest available ILG (0.125% coupon, maturing in 03/73), on 1/2/24 it had a real yield of 0.9%, a clean price of 69.0 and a modified duration of approximately 47 (all values from tradeweb). Very roughly, if the yield were to fall by 1 percentage point, then the price would go up by 47% (it would actually be a bit less than this).

The real yield=nominal yield-implied inflation (where nominal yield is that for a nominal gilt of the same maturity as the inflation linked one and implied inflation is the breakeven difference in yield between the nominal and inflation linked gilts as determined by the market). So, the real yield will go down if nominal gilt yields drop and implied inflation stays the same, or nominal gilt yields stay the same and implied inflation increases (and for various combinations of changes in nominal yields and implied inflation).

What real yields will do over the next two years is anyone's guess, but if real yields do drop then your proposed purchase will pay off. Conversely, if real yields increase, then it won't.

Linton

Index linked gilts will guarantee protection against inflation provided you buy at par and hold until maturity. If you sell significantly before maturity the effect of volatility in the price could outweigh the gain from inflation.

You may be confused between the effect of  inflation and interest rates on IL gilts.  At the moment low coupon (interest) long dated IL gilts are priced below par since current interest rates are above the market's expectations on inflation.  So such gilts are unattractive to the market generally - you would probably be better off  buying fixed rate gilts.  However if interest rates fall IL bonds become more attractive and so prices rise. The short term behaviour of IL bonds is much more dependent on interest rates than short term inflation rates.

However the effect of interest rate changes aklso affects fixed rate gilts as well. So for example long dated fixed rate bonds with a coupon of around 4.5% are currently trading at about par.  So if interest rates fall, 4.5% interest will beome more desirable and the price of the fixed rate gilt will rise.

The coupon paid on IL bonds does not drop unless possibly we have deflation - it is a constant % of the inflation adjusted capital value.  So it will always rise by inflation.

In my view gambling on short term gilt interest rates is a risky business best left to the professionals.  If you want higher risk & return  I suggest you keep to equity, at least you that gives you a significant degree of diversification.

Granddadofyear

Thank you both for your comments! Really useful

Yes I was a bit confused but makes a lot more sense now. With IL gilts - you are expressing a view on real yields:

Real yield = nominal yield - inflation expectations

If inflation falls as I expect, but base rates fall by the same amount - then the return would be wiped out. You buy IL gilts here if you think we are going into a stagflationary period (low economic growth that pushes base rates lower, whilst inflation stays high due to a number of likely reasons).

Seems like the UK economy may be headed that way, but it’s a punt! That being said, it looks pretty clear that interest rates are going to fall over the next 2 years so buying long duration nominal gilts sounds like the best plan. If inflation falls, nominal yields fall. And if inflation doesn’t fall, there are still likely to be a few rate cuts.

Granddadofyear

Just to round up this discussion. I think long duration nominal gilts offer an extremely attractive risk/reward profile.

On the assumption that BOE base rates are going to normalise back towards 3%. Surely this is a question of when and not if - even if it takes more than 2 years. Currently 5.25%, market expects 4.25% by the end of this year alone.

If I take the UKT 0.5% 2061- currently trading around £29 which gives you a yield of 4.35% if held to maturity. When base rates are back to 3%, it won’t be 1:1 but if we assume the 2061 gilts are then trading at 2.50%, this is a cash price of £51. 

I.e. a 75% return on investment.

And of course - capital gains on gilts are exempt from tax.

Does this seems too good to be true? Maybe interest rates take a very long time to come down, but that is the only risk I can identify? Even then, you still earn a small coupon whilst you are waiting and of course - no risk of losing your capital like you could with stocks (providing you are never forced to liquidate the position). 

Any other risk I am not thinking of? Thank you.

Linton

Why do you say that normal interest rates are 3%?  They can spend decades being abnormal.

For example base rates were above 5% for almost the entire period from 1964 until the 2008 crash. Looking further back one could argue that 5% was closer to "normal", but there were periods either significantly higher or lower than that with serious volatility.

See https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy/baserate.xls for data going back to the 1690's.

username12345678

Some interesting comments on IL gilts which answer a couple of questions that I keep coming back to.

After avoiding gilts for many years I have started to slowly build positions in IGLT/VGOV as a counterbalance to the equities. I thought about building a gilt ladder but decided against it as I wasn’t looking to create an income stream in that sense. I may be making a mistake with gilts, there are certainly some knowledgeable people who feel they are a risky addition, but after years of scrabbling around trying to find non-equities that had lower correlations to shares it feels like I need to bite the bullet.

May look back with regret if inflation rips again.

Linton

username12345678 said:

Some interesting comments on IL gilts which answer a couple of questions that I keep coming back to.

After avoiding gilts for many years I have started to slowly build positions in IGLT/VGOV as a counterbalance to the equities. I thought about building a gilt ladder but decided against it as I wasn’t looking to create an income stream in that sense. I may be making a mistake with gilts, there are certainly some knowledgeable people who feel they are a risky addition, but after years of scrabbling around trying to find non-equities that had lower correlations to shares it feels like I need to bite the bullet.

May look back with regret if inflation rips again.

Gilts are only risky if you sell far from maturity.  The longer the time to maturity the greater the risk.  That is why I dislike medium and long bond funds unless one is focussed on the income. Whenever you sell, a significant part of the fund will always be far from maturity.

Granddadofyear

Linton said:

username12345678 said:

Some interesting comments on IL gilts which answer a couple of questions that I keep coming back to.

After avoiding gilts for many years I have started to slowly build positions in IGLT/VGOV as a counterbalance to the equities. I thought about building a gilt ladder but decided against it as I wasn’t looking to create an income stream in that sense. I may be making a mistake with gilts, there are certainly some knowledgeable people who feel they are a risky addition, but after years of scrabbling around trying to find non-equities that had lower correlations to shares it feels like I need to bite the bullet.

May look back with regret if inflation rips again.

Gilts are only risky if you sell far from maturity.  The longer the time to maturity the greater the risk.  That is why I dislike medium and long bond funds unless one is focussed on the income. Whenever you sell, a significant part of the fund will always be far from maturity.

Thanks for your comment. Appreciate your point, nobody knows where rates stabilise. However from what monetary policy members have been saying (in UK but also US and Europe), neutral rates are lower. Maybe they have all underestimated it, and 2% inflation can be reached & sustained with rates at 5%. But can the UK economy also grow sustainably? The data tells you not… cracks are already forming, and policy members will eventually switch focus from inflation to growth. Rates need to be lower.

The beauty of long duration gilts that are trading at such a low cash price right now though is that the “convexity” is hugely in your favour. Long bonds are usually risky but the downside is limited so you can take smart calculated risk… how much cash prices jump on a 1% cut in interest rates hugely outweighs how much the cash price would drop on a further 1% hike. And especially when you probability weigh it… the chance of interest rate cuts vs hikes is probably something like 90% vs 10%. This really looks like a no brainer low risk high reward trade to me - not investment advice, but sharing my thoughts.