Opportunities that really are gilt-edged
An examination of the main attractions of index-linked gilts.
Index-linked gilts, known as 'linkers', offer investors full inflation protection since the value of the bond is indexed to the retail price index (RPI). When the bonds are redeemed, they return the original capital multiplied by the uplift in the RPI index over their lifetime.
So, if RPI grows by 50% between the issue date of the bond and redemption, investors would receive £1.50 for every £1 invested in capital at redemption. The bonds also return a modest coupon, which is also linked to the evolution of RPI, with coupons on the earlier issues generally 2.5% per annum of the uplift in RPI in that year. Investors receive the uplift in the value of the bond tax-free.
Attractive returns
Since they were first issued in 1981, index-linked gilts have offered very attractive returns to investors, and at least matched other asset classes, like equities, or conventional gilts, which are not guaranteed to appreciate in value in line with any nominal index, like RPI.
They also have fixed maturity dates and known duration. For example, the UK index-linked gilt 2.5% of 2020, first issued in 1983, has appreciated from an issue price of 100 in October 1983 to a current price of 370 with relatively low volatility; e.g. a 270% price appreciation over 29 years. This exceeds the appreciation in RPI since issue, because the price of the bond discounts future inflation of approximately 3% per annum, between now and maturity in 2020.
Inflation expectations
Valuations for linkers diverge from the evolution of RPI according to investors' inflation expectations – the price of the bonds is not mechanically tied to the evolution of RPI during the lifespan of the asset. If investors expect a period of higher inflation between now and maturity, prices may be driven to a significant premium relative to RPI uplift to date.
The index-linked 2.5% gilt of 2020, standing at a price of 370, would stand at 291, if it was priced exactly in line with RPI accrual since 1983, which means the bond discounts an extra 27% of RPI accrual between now and 2020 when it matures, e.g. about 3% RPI accrual per annum.
Clearly, the amount of future inflation discounted in current prices will also depend on the time value of money and cash interest rates, and the size of the coupon stream, since investors are buying a stream of discounted future coupons in the current cash price. So linkers with higher coupons, like the 4.125% gilt of 2030, discount more future inflation in the current price. Prices are lower, like all bonds, when cash interest rates are higher, since the value of future dividends and the principal at maturity is reduced. Current economic conditions of stagnant growth and very low cash rates, plus inflation accruals of about 3% per annum, are very attractive for linkers.
Deflation
UK index linkers do not have a floor at 100, unlike other indexlinked government bonds (like US TIPS, Australian or Canadian linkers). This has not been a problem because they were issued in the early 1980s, since when inflation has always been positive year on year.
However, for investors who seek protection against outright deflation, new US TIPS, issued at par, offer that protection. The main attraction of index-linked gilts is as a tax-efficient, capital protection vehicle with no credit or default risk, since they are government-guaranteed, with known maturity dates.
The value of investments in bonds can fall as well as rise and if you do not hold these investments until maturity you may not get back the original amount invested. Investments in bond funds may not behave like direct investments in the underlying bonds themselves. By investing in bond funds the certainty of a fixed income for a fixed period with a fixed return of capital are lost.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
