Inflation-linked bonds – lock in a real yield

I recently said that even though conventional bond yields have risen a long way from their lows, we’re not yet tempted by them for our asset-allocation portfolio, except perhaps very short-dated bonds. 

We’re not forecasting that rates are going much higher in the short term (we forecast as little as possible), but it seems clear that yields don’t offer much compensation for the risk that they do. They seem pretty much at the lower end of where you’d expect them to be. 

Inflation-linked bonds are rather different. At present, ten-year US Treasury inflation-protected securities (TIPS) pay a real yield of about 2.5%, which is almost as high as they’ve been for 20 years (see chart). 

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When they were first issued in the late 1990s, enthusiasm was surprisingly low and real yields were higher – above 4% at times – but it would be optimistic to expect that again. Perhaps investors would again demand higher yields in a very high-inflation world (to compensate for greater uncertainty and the risk of the government fiddling the inflation figures), but on the face of it, Tips yields are not terrible by historical standards. 

Meanwhile, the ten-year break-even inflation rate (the implicit forecast for inflation calculated from the difference between yields on Tips and on conventional bonds) is also now roughly 2.5% (since the yield on conventional ten-year bonds is currently about 5%). 

When break-evens are high relative to probable inflation, it could be a good time to buy conventional bonds; when they are low, it could be a good time to buy linkers. Actual US inflation over the past 20 years has, in fact, been around 2.5% per year, so markets are implying more of the same.

We have no way of knowing whether that will be right, but note that conventional ten-year bonds have returned 1.7% per year after inflation over the past 25 years and 2.6% per year over 50 years. There were periods of higher returns in the 1980s, 1990s and 2000s, but that was with the tailwinds of higher nominal rates and falling inflation. In today’s world, locking a 2.5% real yield via Tips looks at least reasonable value. 

The problem with gilts

As a British investor, why am I focusing on Tips and not UK index-linked gilts here? 

In short, because the UK linker market is messy. First, UK linkers are indexed to the old retail price index (RPI), not the consumer price index (CPI) – but most investors use CPI as a benchmark, so market prices have to reflect expectations for the likely difference between RPI and CPI. 

Second, the link will switch – without compensation – from RPI to CPI, including housing (CPIH), in 2030 creating further complications in valuing them. Third, the prices are distorted by the huge appetite that pension funds have for linkers. At present, real yields on ten-year UK linkers are around 1%. The difference between RPI and CPI is unstable but averages about 1%. So likely returns seem worse and complications abound. Thus we favour Tips in the portfolio. 

However, I’ll look at the choice of exchange-traded funds for both US and UK linkers in my next column.

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