Index-linked bonds could prove a costly inflation hedge

There aren’t many markets where one can feel optimistic about getting a good long-term return, but government bonds are in a uniquely tricky position. UK ten-year government bonds (gilts) are on a yield to maturity – the annualised return if you hold the bond until it’s redeemed – of 1.01%. US ten-year Treasuries yield 1.66%. Other major markets are worse: German Bunds will return -0.22% (that minus sign is not a mistake).

This is far below inflation. The consumer price index (CPI) is rising at an annual rate of 4.2% in the UK and 6.2% in the US. Evidence is growing this is not transitory and while 4%-6% inflation might be more than we expect over ten years, it’s hard to see it falling back to 1%. So the obvious question is whether inflation-linked bonds (see below) are a better choice in this climate than conventional bonds.

Desperate buyers

The problem is that the inflation-linked bond market is fairly small – it’s around £3trn compared to around £100trn for the whole global bond market – and can be distorted by investors who are desperate to hedge their inflation-linked liabilities. So linkers have already become quite expensive, especially in the UK where demand from pension funds is huge.

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UK ten-year inflation-linked gilts currently trade on a negative real yield of -3.2%. The gap between this and the yield on conventional bonds means that the ten-year breakeven rate – what inflation will have to average for linkers to return the same as conventional bonds – is now 4.2%. This slightly overstates how expensive they are, because UK linkers are still indexed to the retail price index (RPI), which tends to run about one percentage point higher than CPI. Hence the breakeven rate in CPI terms might be around 3.2% (although the RPI-CPI relationship is volatile, so this isn’t guaranteed).

US linkers are a little cheaper. The ten-year yields -0.97%, implying a breakeven rate of 2.65%. In addition, most investors will buy linkers through a fund such as the iShares Index-Linked Gilts ETF (LSE: INXG) for UK bonds or the iShares $ Tips ETF (LSE: ITPS) for US ones. So it’s notable that the duration (how sensitive a bond is to rising interest rates) is 21 for INXG but 8.2 for ITPS because the UK has issued more longer-dated bonds (lower duration is better if rates will rise).

US inflation has averaged 1.7%% over the past decade, so it’s not a stretch to see US linkers beating conventional bonds in the next ten years. But negative yields mean you are locking in an up-front loss to reduce the risk of a bigger one. They have a role in asset allocation strategies such as our All-Weather ETF Portfolio (above) to hedge against inflation, but otherwise they don’t look much more compelling than conventional bonds.

I wish I knew what linkers were, but I’m too embarrassed to ask

Conventional bonds have a fixed principal – also known as the face value or the par value – that the bondholder will receive when the bond matures. When inflation is high and maturity is a long way in the future, the real (inflation-adjusted) value of the principal will be much less when the bondholder gets paid than it is today. Assume that you hold a bond that will pay £100 in ten years time, but cumulative inflation over the next decade turns out to be 50%. Then the £100 you get in ten years is worth just £50 today.

Investors can take into account how high they expect inflation to be when deciding what price they are willing to pay for the bond. But inflation forecasts are not very accurate, meaning that they are exposed to substantial uncertainty about whether their investment will beat inflation. Inflation-linked bonds – often known as linkers – are intended to solve this by indexing the principal to inflation. In the example above, a linker would repay £150 in ten years time, not £100.

Any interest payments the investor receives between today and maturity will also rise with inflation. The interest rate remains the constant, but the payment is calculated based on the latest inflation-adjusted principal. So if our bond yields 1%, it would pay £1 (1% × £100) at first, but by the tenth year it would pay £1.5 (1% × £150).

Most linkers are issued by governments. The first recorded inflation-linked bond was issued in 1780 during the American War of Independence, but the idea was not widely adopted until the high-inflation era of the late 20th century. The UK was the first major market to introduce them when it created index-linked gilts in 1981, while the US launched treasury inflation protected securities (Tips) in 1997. Most large economies now issue linkers, but these two still dominate the market. The US accounted for 45% of the Bloomberg Fixed Income Indices in late 2021, while the UK accounted for 30%.