Index-Linked Gilts question

GeoffTF

aroominyork said:

Duration is less of an issue non-UK and, yes, tariff inflation has me looking at that fund. US markets generally seem in denial about what is likely to come.

In the short term tariffs put up prices. The increased prices for essentials take money out of people's pockets. As a result, they cut back on non-essentials. That causes people to lose their jobs, and they have even less money to spend. The reduction in demand potentially leads to deflation. In a mad world where Trump's whims change every few weeks, every bet is off.

aroominyork

masonic said:

aroominyork said:

masonic said:

aroominyork said:

Linton said:

aroominyork said:

They sure are complicated, these ILGs. OK, I get the purpose of linking your returns to UK inflation and matching maturity to your expenditure, but if you want an easier way to go about it - proxying developed world inflation for the UK's and being less time specific - how good a solution is a global index/inflation linked bond fund such as Royal London's or Aberdeen's?

Looking at the RL Global IL Bond fund a quick bit of mental arithmetic suggests that they are something like 50% US.  I would see 3 areas of concern about the fund providing inflation linked returns when you come to sell:
1) currency risk
2) US inflation may be quite different from UK inflation.
3) And then you have the problem of volatility.  Over the past 3 years the fund fell in value by about 8% in Total Return terms.  This was because it contains a significant % of long dated bonds which are strongly affected by interest rate changes.

What are you trying to achieve? How can a global IL bond fund be a good solution to whatever problem would otherwise have led you to buying single IL Gilts?

US tariffs incoming! I've owned Royal London's hedged short duration global index linked bond fund in the past and am thinking about it again. It's about 45% US, 33% UK. Thoughts?

What attracts you to US inflation linked bonds rather than going purely UK? Trying to capitalise on US inflation stoked by the tariffs? Have you been able to get your head around the US market and whether those bonds represent a low enough breakeven inflation rate?

I hold a mix of UK and global bonds and want to shorten UK duration from the index fund's length, and am mulling the inflation link. Duration is less of an issue non-UK and, yes, tariff inflation has me looking at that fund. US markets generally seem in denial about what is likely to come. Good point about breakdown rate though - any info you can offer?

Well I know that the 5 year TIPS yield is currently 1.4% and the 5 year Treasury 3.8%, and the 5 year average expected US CPI rate was 2.4% as of Monday. So if you think that figure didn't price in what happened overnight there's a chance short-dated TIPS will give you a better overall return. But I can't see the attraction over ILG, when they are pegged to a more generous inflation measure, don't carry any currency/hedging risk, and don't carry any risk of being caught up in collateral damage from further financial sanctions, like the threat of conversion to 100 year Treasuries.

I've been dialling down my exposure to US bonds. It is currently half of what it at the start of the year (all hedged and none of it index linked). I see no upside, only potential downsides.

That's interesting. Is the point that most ILGs are sold to meet institutional requirements, so the fact that it's based on RPI rather than CPI doesn't result in increased demand which, in a more market-driven situation, would force up their price?

masonic

aroominyork said:

masonic said:

aroominyork said:

masonic said:

aroominyork said:

Linton said:

aroominyork said:

They sure are complicated, these ILGs. OK, I get the purpose of linking your returns to UK inflation and matching maturity to your expenditure, but if you want an easier way to go about it - proxying developed world inflation for the UK's and being less time specific - how good a solution is a global index/inflation linked bond fund such as Royal London's or Aberdeen's?

Looking at the RL Global IL Bond fund a quick bit of mental arithmetic suggests that they are something like 50% US.  I would see 3 areas of concern about the fund providing inflation linked returns when you come to sell:
1) currency risk
2) US inflation may be quite different from UK inflation.
3) And then you have the problem of volatility.  Over the past 3 years the fund fell in value by about 8% in Total Return terms.  This was because it contains a significant % of long dated bonds which are strongly affected by interest rate changes.

What are you trying to achieve? How can a global IL bond fund be a good solution to whatever problem would otherwise have led you to buying single IL Gilts?

US tariffs incoming! I've owned Royal London's hedged short duration global index linked bond fund in the past and am thinking about it again. It's about 45% US, 33% UK. Thoughts?

What attracts you to US inflation linked bonds rather than going purely UK? Trying to capitalise on US inflation stoked by the tariffs? Have you been able to get your head around the US market and whether those bonds represent a low enough breakeven inflation rate?

I hold a mix of UK and global bonds and want to shorten UK duration from the index fund's length, and am mulling the inflation link. Duration is less of an issue non-UK and, yes, tariff inflation has me looking at that fund. US markets generally seem in denial about what is likely to come. Good point about breakdown rate though - any info you can offer?

Well I know that the 5 year TIPS yield is currently 1.4% and the 5 year Treasury 3.8%, and the 5 year average expected US CPI rate was 2.4% as of Monday. So if you think that figure didn't price in what happened overnight there's a chance short-dated TIPS will give you a better overall return. But I can't see the attraction over ILG, when they are pegged to a more generous inflation measure, don't carry any currency/hedging risk, and don't carry any risk of being caught up in collateral damage from further financial sanctions, like the threat of conversion to 100 year Treasuries.

I've been dialling down my exposure to US bonds. It is currently half of what it at the start of the year (all hedged and none of it index linked). I see no upside, only potential downsides.

That's interesting. Is the point that most ILGs are sold to meet institutional requirements, so the fact that it's based on RPI rather than CPI doesn't result in increased demand which, in a more market-driven situation, would force up their price?

I don't know why the market is as it is. The UK has its own problems, which have driven yields up. But this means there is already a premium built in that seems to be lacking in the US. Also, our bond markets are less attractive to foreign investors than those of the US (at least for now). On RPI, we should make the most of this, since in less than 5 years it will be aligned with CPIH. You can see the market's appraisal of that in the ILG yield curve.

GeoffTF

aroominyork said:

masonic said:

aroominyork said:

masonic said:

aroominyork said:

Linton said:

aroominyork said:

They sure are complicated, these ILGs. OK, I get the purpose of linking your returns to UK inflation and matching maturity to your expenditure, but if you want an easier way to go about it - proxying developed world inflation for the UK's and being less time specific - how good a solution is a global index/inflation linked bond fund such as Royal London's or Aberdeen's?

Looking at the RL Global IL Bond fund a quick bit of mental arithmetic suggests that they are something like 50% US.  I would see 3 areas of concern about the fund providing inflation linked returns when you come to sell:
1) currency risk
2) US inflation may be quite different from UK inflation.
3) And then you have the problem of volatility.  Over the past 3 years the fund fell in value by about 8% in Total Return terms.  This was because it contains a significant % of long dated bonds which are strongly affected by interest rate changes.

What are you trying to achieve? How can a global IL bond fund be a good solution to whatever problem would otherwise have led you to buying single IL Gilts?

US tariffs incoming! I've owned Royal London's hedged short duration global index linked bond fund in the past and am thinking about it again. It's about 45% US, 33% UK. Thoughts?

What attracts you to US inflation linked bonds rather than going purely UK? Trying to capitalise on US inflation stoked by the tariffs? Have you been able to get your head around the US market and whether those bonds represent a low enough breakeven inflation rate?

I hold a mix of UK and global bonds and want to shorten UK duration from the index fund's length, and am mulling the inflation link. Duration is less of an issue non-UK and, yes, tariff inflation has me looking at that fund. US markets generally seem in denial about what is likely to come. Good point about breakdown rate though - any info you can offer?

Well I know that the 5 year TIPS yield is currently 1.4% and the 5 year Treasury 3.8%, and the 5 year average expected US CPI rate was 2.4% as of Monday. So if you think that figure didn't price in what happened overnight there's a chance short-dated TIPS will give you a better overall return. But I can't see the attraction over ILG, when they are pegged to a more generous inflation measure, don't carry any currency/hedging risk, and don't carry any risk of being caught up in collateral damage from further financial sanctions, like the threat of conversion to 100 year Treasuries.

I've been dialling down my exposure to US bonds. It is currently half of what it at the start of the year (all hedged and none of it index linked). I see no upside, only potential downsides.

That's interesting. Is the point that most ILGs are sold to meet institutional requirements, so the fact that it's based on RPI rather than CPI doesn't result in increased demand which, in a more market-driven situation, would force up their price?

ILGs are linked to RPI only until 2030:

https://www.lcp.com/media/1150122/202008-rpi-will-be-aligned-to-cpih-from-2030-with-no-compensation-for-holders-of-index-linked-gilts.pdf

The price people are willing to pay inevitably depends on the payout. The institutions sued the government when the rules were changed, but they lost.

aroominyork

masonic &  GeoffTF (I’m too old to do the ‘@’ thing), are you saying there is an PRI premium that will disappear post-2030? masonic, you say “You can see the market's appraisal of that in the ILG yield curve.”. Can you please post or link to that? The view I was positing is that demand for gilts is not driven essentially by whether they represent value (RPI rather than CPI) but by institutional demand to meet future redemptions. Please educate me!

masonic

aroominyork said:

masonic &  GeoffTF (I’m too old to do the ‘@’ thing), are you saying there is an PRI premium that will disappear post-2030? masonic, you say “You can see the market's appraisal of that in the ILG yield curve.”. Can you please post or link to that? The view I was positing is that demand for gilts is not driven essentially by whether they represent value (RPI rather than CPI) but by institutional demand to meet future redemptions. Please educate me!

I would point you to the Bank of England's yield curve graph for implied inflation, and the real yield vs nominal yield data to calculate breakeven inflation across durations.

I don't think you'll find much evidence that the market will be compensating investors for the lower rate of index linking post-2030.

Whether this is going to happen at some point in the future (i.e further price falls at the long end of the curve) I do not know, but it seems unlikely given it's been known about for quite a long time now.

Either way, if you buy a ILG today with a maturity much beyond 2030, you won't be getting as good a deal as you could in the past (low interest rate era excepted).

zagfles

masonic said:

aroominyork said:

masonic &  GeoffTF (I’m too old to do the ‘@’ thing), are you saying there is an PRI premium that will disappear post-2030? masonic, you say “You can see the market's appraisal of that in the ILG yield curve.”. Can you please post or link to that? The view I was positing is that demand for gilts is not driven essentially by whether they represent value (RPI rather than CPI) but by institutional demand to meet future redemptions. Please educate me!

I would point you to the Bank of England's yield curve graph for implied inflation, and the real yield vs nominal yield data to calculate breakeven inflation across durations.

I don't think you'll find much evidence that the market will be compensating investors for the lower rate of index linking post-2030.

Whether this is going to happen at some point in the future (i.e further price falls at the long end of the curve) I do not know, but it seems unlikely given it's been known about for quite a long time now.

Either way, if you buy a ILG today with a maturity much beyond 2030, you won't be getting as good a deal as you could in the past (low interest rate era excepted).

I think it's fairly clear just from looking at clean prices that the market is accounting for the lower index linking post 2030. For instance the 2029 and 2036 ILGs have the same 0.125% coupon, the clean price for the 2029 is 98.275 and for 2036 is 85.3, so the annualised capital gain is around 0.5% for 2029 and 1.4% for 2036 above the inflation measure.

Linton

zagfles said:

masonic said:

aroominyork said:

masonic &  GeoffTF (I’m too old to do the ‘@’ thing), are you saying there is an PRI premium that will disappear post-2030? masonic, you say “You can see the market's appraisal of that in the ILG yield curve.”. Can you please post or link to that? The view I was positing is that demand for gilts is not driven essentially by whether they represent value (RPI rather than CPI) but by institutional demand to meet future redemptions. Please educate me!

I would point you to the Bank of England's yield curve graph for implied inflation, and the real yield vs nominal yield data to calculate breakeven inflation across durations.

I don't think you'll find much evidence that the market will be compensating investors for the lower rate of index linking post-2030.

Whether this is going to happen at some point in the future (i.e further price falls at the long end of the curve) I do not know, but it seems unlikely given it's been known about for quite a long time now.

Either way, if you buy a ILG today with a maturity much beyond 2030, you won't be getting as good a deal as you could in the past (low interest rate era excepted).

I think it's fairly clear just from looking at clean prices that the market is accounting for the lower index linking post 2030. For instance the 2029 and 2036 ILGs have the same 0.125% coupon, the clean price for the 2029 is 98.275 and for 2036 is 85.3, so the annualised capital gain is around 0.5% for 2029 and 1.4% for 2036 above the inflation measure.

Couldn’t the difference arise from the market expectations on short term and longer term inflation?

zagfles

Linton said:

zagfles said:

masonic said:

aroominyork said:

masonic &  GeoffTF (I’m too old to do the ‘@’ thing), are you saying there is an PRI premium that will disappear post-2030? masonic, you say “You can see the market's appraisal of that in the ILG yield curve.”. Can you please post or link to that? The view I was positing is that demand for gilts is not driven essentially by whether they represent value (RPI rather than CPI) but by institutional demand to meet future redemptions. Please educate me!

I would point you to the Bank of England's yield curve graph for implied inflation, and the real yield vs nominal yield data to calculate breakeven inflation across durations.

I don't think you'll find much evidence that the market will be compensating investors for the lower rate of index linking post-2030.

Whether this is going to happen at some point in the future (i.e further price falls at the long end of the curve) I do not know, but it seems unlikely given it's been known about for quite a long time now.

Either way, if you buy a ILG today with a maturity much beyond 2030, you won't be getting as good a deal as you could in the past (low interest rate era excepted).

I think it's fairly clear just from looking at clean prices that the market is accounting for the lower index linking post 2030. For instance the 2029 and 2036 ILGs have the same 0.125% coupon, the clean price for the 2029 is 98.275 and for 2036 is 85.3, so the annualised capital gain is around 0.5% for 2029 and 1.4% for 2036 above the inflation measure.

Couldn’t the difference arise from the market expectations on short term and longer term inflation?

Of course. But the idea that a known future change in the way indexation works which will almost certainly lead to lower inflation uplift is not already priced in seems unrealistic. 

masonic

zagfles said:

masonic said:

aroominyork said:

masonic &  GeoffTF (I’m too old to do the ‘@’ thing), are you saying there is an PRI premium that will disappear post-2030? masonic, you say “You can see the market's appraisal of that in the ILG yield curve.”. Can you please post or link to that? The view I was positing is that demand for gilts is not driven essentially by whether they represent value (RPI rather than CPI) but by institutional demand to meet future redemptions. Please educate me!

I would point you to the Bank of England's yield curve graph for implied inflation, and the real yield vs nominal yield data to calculate breakeven inflation across durations.

I don't think you'll find much evidence that the market will be compensating investors for the lower rate of index linking post-2030.

Whether this is going to happen at some point in the future (i.e further price falls at the long end of the curve) I do not know, but it seems unlikely given it's been known about for quite a long time now.

Either way, if you buy a ILG today with a maturity much beyond 2030, you won't be getting as good a deal as you could in the past (low interest rate era excepted).

I think it's fairly clear just from looking at clean prices that the market is accounting for the lower index linking post 2030. For instance the 2029 and 2036 ILGs have the same 0.125% coupon, the clean price for the 2029 is 98.275 and for 2036 is 85.3, so the annualised capital gain is around 0.5% for 2029 and 1.4% for 2036 above the inflation measure.

The 2029 ILG has a real YTM of 0.6%, whereas the closest nominal equivalent TG29 a nominal YTM of 3.7%, giving an implied RPI of 3.1%.

For the 2036 ILG, it's 1.5%, and T4Q 4.6%, giving 3.1%

Going out much further, for T68, it's 2.0% and TR68, 5.2%, giving 3.2%.

Historically, the difference between RPI and CPI/CPIH has been ~0.9%, so one should expect an increase in nominal coupon relative to flat gilts and a decrease in breakeven rate. There doesn't seem to be any evidence of that. The market's long term expectation of inflation, beyond 10 years or so, tends to be quite constant, because it cannot predict when high or low inflation periods will fall, and so you'd expect it to be flat if the measure of inflation remained constant, or trend downwards if a new, less generous, measure of inflation were introduced, in proportion to the proportion of time index linking would accrue according to the lower measure.

Following the announcement of the uncompensated alignment in late 2020, the immediate reaction of the market was to price inflation slightly higher, which is the opposite of what would have been expected, but perhaps it was muted by pent up demand for inflation hedging, or had been priced in earlier, in the 2010s, but if you look at yield curves from that era, that are shaped quite similarly to those around 2020.

I do agree it seems implausible that a change anticipated for years and then confirmed 10 years ahead of implementation would not be priced in, but that is exactly what the data is telling me. Perhaps an explanation for this is that ILG are primarily liability driven investments and their principal liability (RPI linked annuities) will also see the same effect. Pension funds will not lose out if they are receiving less and paying out less due to RPI aligning with CPIH. Though using ILG for other purposes may result in a shortfall.

The only conclusion I can reach is that investors will get a lower overall rate of return from these longer duration instruments, without compensation arising from market pricing. They will just have to live with a new, lower, inflation benchmark and live with them being a somewhat less attractive investment than they have been historically. Just as those who have annuitised with RPI-linking will have to do.