Gilts - inflation linked Vs nominal check

Bobziz

Hi, I'm looking at securing 2 years of £20k in 2036&7. Using the ladder building tool it suggests that using nominal gilts would cost about £25k and using linkers would cost £34k. Is the £9k difference a reflection that markets currently think inflation will/might run a fair bit higher than the 3% the tool uses or have I got that wrong ?

Many thanks

InvesterJones

Or that the inflation linked market is willing to pay a premium to hedge against the risk inflation will be higher. Break even on TG36 is 3.38% (and TR37 is 3.37%) so if inflation averages less than that the conventional gilt would return more.

phlebas192

With non-index linked gilts you will get exactly £20k return for each of the two years. With index-linked you will get £20k adjusted for inflation. ie the return is likely to be significantly higher and hence costs more in today's money.

Linton

https://forums.moneysavingexpert.com/discussion/comment/81971551#Comment_81971551

It is more complex than that. The fixed gilt will generally include a reasonable % ongoing interest whereas the IL gilt's will in most cases be much lower. The markets will adjust the prices such that the overall return assuming expected inflation is much the same.

At the moment normal interest rates are higher than expected inflation so IL gilts are actually cheaper (clean price) than fixed ones.

Note that if you use dirty prices for IL gilts you are including all inflation received by the gilt prior to your purchase. So a 20 year old IL Gilt would have a much higher dirty price than an equivalent new IL Gilt. But the return to you for a £n investment would be the same. So when considering IL Gilts it is much simpler to think in terms of the clean price and buying £n worth rather than the dirty price per gilt.

phlebas192

https://forums.moneysavingexpert.com/discussion/comment/81971582#Comment_81971582

It is more complex than that. The fixed gilt will generally include a reasonable % ongoing interest whereas the IL gilt's will in most cases be much lower. The markets will adjust the prices such that the overall return assuming expected inflation is much the same.

The gilt ladder tool takes the coupons into account. With non-index linked it produces cash flows equalling £40k (£20k per year) comprising both the coupons and redemption value. With index linked it does the same but produces £40k in todays money which will be considerably higher in 10 years time (approx £54k if the assumed inflation rate of ~3% holds). ie with ILs you would expect to get about a third more cash back and hence it costs about a third more.

Bobziz

https://forums.moneysavingexpert.com/discussion/comment/81971674#Comment_81971674

Thanks, so this makes sense and explains the £9k difference, which would seem an excessive premium for inflation protection. However, my understanding, which is perhaps incorrect, is that the gilt ladder builder assumes 3% inflation, so I had assumed the £40k was £40k including 3% inflation, albeit it would deviate from £40k according to the actual inflation over the period.

phlebas192

It assumes 3% inflation in order to be able to present cash flow balances in today's money when using ILGs. eg if there was a balance of £100 then after a year it would be reduced to £97.08 (100 / 1.03), after 2 years to £94.26 (97.08 / 1.03) and so on. In most cases where cash is being withdrawn regularly it doesn't make too much of a difference but it is noticable in scernarios like yours where the early coupons aren't going to be withdrawn for nearly 10 years - in reality you probably would remove or reinvest them, but the tool assumes you won't..

hara____

You might want to consider a few scenarios to make sure you understand the pros and cons of nominals and linkers. Not too hard to do seeing as you're basically talking about a lump sum return after 10 years.

For nominals, the ten year yield is about 4.8% so, as you say, the calculation is roughly:

25000*(1.048^10) = 40000

Whereas for linkers you don't know what the nominal return will be as it will depend on inflation. The real yield right now is about 1.6% for the ten-year, so if you consider scenarios for 2%, 3% and 4% inflation you would be looking at (crudely):

25000*(1.036^10) = 36000

25000*(1.046^10) = 39000

25000*(1.056^10) = 43000

So if inflation is 3%, there won't be much difference between the returns from nominals and linkers. But if inflation is much above that, linkers win.

And while it's common to talk about breakeven inflation, I tend to think it's best to see linkers as providing insurance against extreme scenarios, meaning scenarios more extreme than any of those above. Then the question is how valuable is that insurance to you as an individual.

Bobziz

https://forums.moneysavingexpert.com/discussion/comment/81972540#Comment_81972540

Thank you, that's very helpful and is I think where I'd just about got to in my understanding. I can live with a few k under but would like protection against any large spikes.

Where I think I'd got myself confused was in working out what my likely income gap might be in 10 years assuming a given rate of inflation i.e £15k short in today's money might equate to £20k in 10 years. Using the tool to work out how much it would cost to buy that £20k x 2 using nominals. I then made the mistake of seeing how much it would cost to buy £20k x 2 using linkers and baulked at the significant additional cost.

I now understand that if using linkers then I need to buy £15k x 2, which is pretty much the same cost as nominals. Hopefully I have that correct ? If I do then my next question is why would anyone buy nominal gilts unless they had a fixed liability ?

phlebas192

https://forums.moneysavingexpert.com/discussion/comment/81972623#Comment_81972623

I now understand that if using linkers then I need to buy £15k x 2, which is pretty much the same cost as nominals. Hopefully I have that correct ? If I do then my next question is why would anyone buy nominal gilts unless they had a fixed liability ?

Yes, you've got that right - assuming of course that the current implied inflation rate difference between linkers & nominals proves to be reasonably accurate. Linkers give you certainty in current spending power so if that is what you are after they are lower risk.

To date, we've only bought non-index linked gilts. That's for three reasons. Firstly it is to generate enough cash to top up my wife's SIPP withdrawals each March to maximise her basic rate tax band. Since the BR band isn't increasing with inflation for the foreseeable future then there is no point in having the payments increase with inflation. Secondly, it is to generate cash from the coupons to fund her monthly withdrawals - ILGs have low coupons so aren't much use in this regard. Thirdly, it is a judgement call that if things go really badly then governments are going to prioritise low interest rates / low inflation over low unemployment for the next decade or so.

I'm increasingly of the opinion that the third point is probably wrong. Since we've now got enough maturities purchased to meet the needs of the first point until she reaches state pension age, future gilt purchases are probably going to be ILGs as long as they will provide a real return.

Linton

Fixed gilts have the advantage that their interest is fixed in £ terms for their lifetime at the point you buy unlike savings accounts which are limited to 5 years maximum. Also when interest rates fall their price increases. So it could be worth buying fixed gilts when interest rates are high as they are now.

of course you are taking the risk that high interest rates could go even higher.

Personally I see little attraction since equity and corporate bonds provide better returns but they could reasonably form part of a risk averse investor’s portfolio.