Index-Linked Gilts question

GeoffTF

masonic said:

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%.

...

...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.

TG36 has about 4 years to run with RPI linking, and 7 years with CPIH linking. TR68 has about 4 years with RPI linking, and 64 years with CPIH linking. Within the limits of accuracy, we can say that 2.0% is the long run real return with CPIH linking. We would expect the real return for TG36 to be (4*0.6% + 7*2.0%) / 11 = 1.49%. That tallies.

In the long term, RPI has been about 0.9% more than CPIH. 0.6% + 0.9% = 1.5%, which is less than 2.0%. The longer dated ILGs should have a higher annualised return than T29, after allowing for the same inflation measure in both cases.

As you say, pension funds and annuity providers should not lose out for existing contracts. The ILGs that back these are not traded and do not affect the market price. Perhaps potential new annuitants will be put off by the lower real returns. I expect that effect will be quite weak, given the current high interest rates and the changes to inheritance tax. Private investors looking for 0.125% gilts will find only index linked ones beyond 2029. It looks like we will have to put up with the effectively higher break even rates after 2030.

aroominyork

So is your view, masonic, that zagfles' "capital gain is around 0.5% for 2029 and 1.4% for 2036 above the inflation measure" simply reflects the premium for longer duration? 

If so, presumably iShares Up to 10 Years Index Linked Gilt Index, with ~5 years effective duration, would have about half its return affected by the uncompensated move to CPI, so an individual ILG with similar duration (T29/TR31) should show a better return (ignoring variables which affect a fund as opposed to an individual bond).

masonic

aroominyork said:

So is your view, masonic, that zagfles' "capital gain is around 0.5% for 2029 and 1.4% for 2036 above the inflation measure" simply reflects the premium for longer duration? 

If so, presumably iShares Up to 10 Years Index Linked Gilt Index, with ~5 years effective duration, would have about half its return affected by the uncompensated move to CPI, so an individual ILG with similar duration (T29/TR31) should show a better return (ignoring variables which affect a fund as opposed to an individual bond).

I can't see any evidence that there is a premium in the nominal yield to counter the reduction in inflation uplift, given the nominal yield curve is once again rising.

A change in inflation measure would break the rough equivalence of a collection of bonds to behave as one of the weighted average duration, but only slightly. It is not as though ILG with maturities beyond 2030 are index linking with CPIH now. However, as we know nothing about where interest rates or inflation expectations will be in 5 years time, one cannot predict whether the fixed real return from T29/TR31 will be better than the variable return from the fund. If inflation remains under control and interest rates follow expectations, then the individual holdings would have an edge. If we end up in a recession then the fund will have upside that the individual gilt does not. Whereas the inflationary path with rate increases would disfavour the fund.

Another way of looking at it is that with the fund some of your money will be going into issues up to TR35 (well, soon it will). If instead you put it all into T29/TR31, then in 4-6 years time, you'll have money to reinvest and may be able to buy those longer duration issues on better or worse terms, and that could impact your overall return more than holding them while they rose with RPI in the first scenario.

aroominyork

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.

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?

Just pointing out that I mentioned this first   

masonic said:

aroominyork said:

So is your view, masonic, that zagfles' "capital gain is around 0.5% for 2029 and 1.4% for 2036 above the inflation measure" simply reflects the premium for longer duration? 

If so, presumably iShares Up to 10 Years Index Linked Gilt Index, with ~5 years effective duration, would have about half its return affected by the uncompensated move to CPI, so an individual ILG with similar duration (T29/TR31) should show a better return (ignoring variables which affect a fund as opposed to an individual bond).

I can't see any evidence that there is a premium in the nominal yield to counter the reduction in inflation uplift, given the nominal yield curve is once again rising.

Yup, I meant nominal yield curve - I just keep forgetting the right terms 

masonic

aroominyork said:

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.

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?

Just pointing out that I mentioned this first   

Indeed you did. Add to that the Treasury has more or less a monopoly on UK inflation linked investments. If there was an alternative product competing with ILG and having a more attractive sequence of cash flows, then perhaps more holders would have dumped them and driven prices down. I wonder if it also had something to do with the change being announced at a time when the YTM was really unattractive, so very few discerning investors would have been holding them.

A bit like the old Index Linked Savings Certificates. A few are still hanging on to those and swearing by them, despite them moving from RPI+1% or thereabouts to CPI+pennies, and from generous access terms to quite restrictive. Everyone willing to look elsewhere and accept a different type of cash flow got shook out many years ago.

zagfles

masonic 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.

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.

Thanks, interesting analysis. Reminds me of a previous thread where we were discussing the apparent illogical market pricing of gilts. Global or UK bond index - which and why? - Page 2 — MoneySavingExpert Forum

If as you say the main users are pension funds etc using them for liability matching and they drown out the effect of speculators and active investment funds looking for opportunities to beat the market then that may make sense, I guess even the vast majority of gilt funds tend to be passive rather than actively managed. 

Maybe I was right in the previous thread and there's opportunity here to take advantage of this apparent market inefficiency!

masonic

zagfles said:

masonic 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.

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.

Thanks, interesting analysis. Reminds me of a previous thread where we were discussing the apparent illogical market pricing of gilts. Global or UK bond index - which and why? - Page 2 — MoneySavingExpert Forum

If as you say the main users are pension funds etc using them for liability matching and they drown out the effect of speculators and active investment funds looking for opportunities to beat the market then that may make sense, I guess even the vast majority of gilt funds tend to be passive rather than actively managed. 

Maybe I was right in the previous thread and there's opportunity here to take advantage of this apparent market inefficiency!

There are some interesting views about the market being wrong on this. For example https://www.youtube.com/watch?v=nxj_ToBBTGQ&pp=ygUgaW5kZXggbGlua2VkIGdpbHRzIG5vdCBwcmljZWQgaW4%3D

I don't buy that there's going to be some future pricing in event personally, but perhaps there is some shorting money to be made.

nonolerigolo

Would you have any idea on shorting money example ? Thank you

masonic

nonolerigolo said:

Would you have any idea on shorting money example ? Thank you

It was not a serious suggestion, and I don't think anyone should actually try to do it.

I guess if you were a holder of long dated ILG and wanted to hedge the risk of them falling in price, you'd need to do so through an account that lets you trade derivatives. Perhaps there is a spead bet or CFD option. An easier solution would be not to hold them. Go short dated or non-index linked, depending on your purpose for them.

Or if like me you believe the market won't react, do nothing (though I have no exposure to long ILG in my portfolio anyway).

zagfles

masonic said:

zagfles said:

masonic 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.

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.

Thanks, interesting analysis. Reminds me of a previous thread where we were discussing the apparent illogical market pricing of gilts. Global or UK bond index - which and why? - Page 2 — MoneySavingExpert Forum

If as you say the main users are pension funds etc using them for liability matching and they drown out the effect of speculators and active investment funds looking for opportunities to beat the market then that may make sense, I guess even the vast majority of gilt funds tend to be passive rather than actively managed. 

Maybe I was right in the previous thread and there's opportunity here to take advantage of this apparent market inefficiency!

There are some interesting views about the market being wrong on this. For example https://www.youtube.com/watch?v=nxj_ToBBTGQ&pp=ygUgaW5kZXggbGlua2VkIGdpbHRzIG5vdCBwcmljZWQgaW4%3D

I don't buy that there's going to be some future pricing in event personally, but perhaps there is some shorting money to be made.

Or maybe it's the other way round. CPIH average over the last 10 years has been 3.3%, so if the market has priced in 3.1% inflation then maybe it's not long dated gilts that are overpriced but shorter dated ones underpriced! Either that or the market is expecting inflation to be lower than usual over the next 5 years.