Gilts are sterling bonds issued by the Bank of England and listed on the London Stock Exchange. They carry a very low risk of default – the government has never missed a payment. Index-linked gilts were first introduced in 1981 to act as a hedge against inflation for the pension funds, and other types of investor soon picked up on them. By the end of March 2002 they made up 26% of the government’s gilt portfolio.
With an index-linked gilt, both the income from the semi-annual coupon payments and the price at which it will be redeemed when it matures are adjusted to take account of the movement in retail prices. The way this is done is by raising and lowering the redemption price in line with the retail prices index (RPI) so that both the income and the capital retain their real value – although in practice, they do not match it exactly.
Index-linked gilts tend to be more popular when inflation-fears rise. Their extra level of safety comes at a price – index-linked gilts usually have a much lower nominal coupon rate.