Steer clear of inflation-linked gilts

Inflation is becoming a worry for many investors. The UK retail price index (RPI) hit 3.7% in January, while the Bank of England hasn't ruled out printing more money if the economy slips back. So it's little wonder that many readers are asking about index-linked gilts ('linkers'). These inflation-protected bonds are popular the last government auction received nearly twice as many bids as there were bonds available. But we wouldn't pile in. Here's why.

Why inflation hurts

Inflation is a nightmare for savers. Unless they use a tax-free individual savings account (Isa), a higher-rate taxpayer would need to secure an interest rate of around 6.2% just to break even after tax and RPI inflation. Yet even the best five-year bonds only offer 5% or so. And unless your employer is offering inflation-busting pay rises (unlikely right now), rising prices also eat away at your disposable income. So, if you think Britain is in for a dose of inflation, buying protection makes sense.

Gilts a solution?

Around 80% £680bn-odd of UK government IOUs (gilts) in issue have fixed coupons. So they pay you, say, a fixed 5% coupon (or £5 per £100 nominal value) every year. The trouble is, as inflation takes off, the value of this fixed payment shrinks. Linkers, on the other hand (which account for the other £180bn or so of gilts in issue), offer an inflation-adjusted coupon. That means the initial rate tends to be lower say, 1.25%. But the fixed amount you receive at each semi-annual coupon date, and the principal due on redemption, rises to reflect any change in the retail price index. See here for a full explanation of how this is calculated. Prices look toppy

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Sounds good. Buy a linker and you have a government-backed security that also offers inflation protection. But it's not that simple. Like other gilts, linkers trade in an open market. So the price is set by supply and demand. There is just one issuer: the UK government. But there are many potential buyers, including most pension funds. As many pensioners expect their pension to be linked to inflation, fund managers need investments, such as linkers, that offer a matching income stream.

Investors can test whether gilt prices look competitive using yields. These measure your expected annual return as a percentage of the current price. You can either look at nominal (pre-inflation), or real (after-inflation) yields. Since the whole point of a linker is that it offers some sort of inflation-proofing, real yields are quoted more often. And right now, these don't look too hot.

"Panic buying" means anyone buying linkers now is probably overpaying for inflation protection, Kevin Doran at Brown Shipley tells Citywire. For example, the real yield on offer at the 27January auction worked out at around 0.7%. As Doran notes, that's quite a result for the government. But why is a real yield of 0.7% not a good result for linker buyers?

Real yields are real low

As Doran says, "real yields on most index-linked gilts are derisory". That's not just in historic terms, but also against equivalent US and German bonds. In theory, the real yield on, say, a medium-term (ten-year) linker ought to be somewhere near the economy's expected real rate of economic growth. Sure, recent figures have been dire as we try to climb out of the worst recession in decades. Capital Economics' Vicky Redwood is pencilling in just 1% growth for this year on the back of the latest bad export data. But while few investors expect the last decade's 2.7% annual rate to be repeated again soon, "growth in the region of 2% (closer to its long-term average) is certainly achievable", says Doran.

So, low yields almost certainly reflect in part a linker supply crunch. The government could issue more. But it won't. That's because its back-pocket option of inflating away huge government debt then becomes harder. As inflation rises, the real value of outstanding fixed coupon government debt falls (just as inflation erodes the real value of your outstanding mortgage balance as a homeowner). But the cost of servicing outstanding linkers also mounts.

Do you trust the UK government?

The government has also developed a nasty habit of making retrospective changes to tax rules. This should warn you that should it get desperate enough, it might tear up the rulebook in any area to save money. As Tim Price of PFP Wealth Management notes, should hyperinflation break out (an "in extremis" concern), the government might "unilaterally change the terms of coupon and redemption payments for index-linked bonds". In short, they might "whip away the inflation protection just when you need it most".

What to buy instead

Picking decent linkers (all have different coupons and maturities), especially given low real yields, is tough. An easier way to hedge inflation for most private investors is to buy an RPI-linked national savings certificate. There are two certificates a three-year and a five-year offering the RPI plus 1%. You can invest up to £15,000 in both but must hold them to maturity to get the full benefit. If you're willing to risk your capital, you could invest in blue-chip stocks. Many offer above-inflation dividends. As many defensives are now better value than other stocks, they offer the prospect of a capital profit to boost returns.