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.