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Why UK inflation-linked funds may not protect you against inflation

Inflation protection is costly

Rampant inflation is Public Enemy No 1 for most investors. (That is assuming you’ve already got yourself and the active fund industry behind bars).

Our standard defence? Index-linked government bonds – affectionately known as ‘linkers’ in the UK.

Linkers are a special type of government bond1 that automatically pump up your regular coupons and ultimate principal payouts in line with RPI inflation.

The easiest way to buy ‘em? Index-linked government bond tracker funds.

But there’s a problem with these funds in the UK – a potential mismatch between what you may think you’re buying and what you’re actually buying.

There’s a danger that your inflation protection could be drowned out by interest rate risk – that is, the possibility that your bond fund suffers large capital losses if market interest rates do take off.

The reason for this is that the UK’s index-linked bond funds are stuffed full of linkers that mature many decades from now.

These long-dated bonds (maturing in the 2030s, ’40s, ’50s and ’60s) are highly sensitive to market interest rate changes.

Fluctuating prices and yields

When market interest rates fall, bond prices rise because their coupons (that is the rate of regular interest they pay) are more competitive compared to new issues coming on to the market.

Investors buy more of the more generous-paying bonds, driving up their prices and reducing their yield, until they trade in line with their peers and the new, lower interest rate regime.

The same is true in reverse. When interest rates rise, a bond’s price falls as its fixed coupon now compares less impressively with the vigorous income-bearers hitting the scene.

Investors will no longer pay as much for existing bonds, given their yields looks a bit skinny compared to the competition. Hence prices fall, until again yields are trading appropriately across the spectrum of bonds in issue.

See old Monevator articles from the attic for more on bond prices and yields.

Note that for very liquid government bonds, these fluctuations usually happen near instantaneously as the market’s perception about future interest rates changes all the time.

It’s kinda like a non-stop debutant’s ball, with the older bonds looking more or less lustrous versus the new generation, depending on how well nourished they are.

So far, so just-about-simple. But wait – don’t go calling Goldman Sachs just yet thinking you’re the next big thing in bond trading. There’s more!

The vast majority of government bonds are issued with a fixed lifespan, with the government promising to repay a particular tranche of bonds’ face value on some far-flung future date.

This date is indicated in the bond’s name.

For instance the UK Gilt Treasury 4.5% 2034 bond will be redeemed in 2034, which at the time of writing is just shy of 18 years away. Until then this particular bond will pay 4.5% a year (although as described above, the actual yield you’ll get from you bond will depend on the price you paid for it).

But here’s the bit that’s on the test as far as today’s article is concerned: The greater the number of coupon payments your bond has still to make until it matures, the more its price will fall or rise with interest rates.

That’s because a so-called long bond is stuck with its relative advantage or disadvantage for more years into the future than is the case with a short bond.

(A long bond is one where there’s a long time until it matures and is redeemed – at least ten years or more. A short bond is one that will mature in the next few years).

Duration and risk

The critical metric for this is called duration.

Your bond fund’s duration should be published on its factsheet. It tells you how susceptible the fund is to market interest rate changes.

The longer the maturity dates of the fund’s bond holdings – and the lower their coupons – the bigger the duration number. The bigger the duration number, the more volatile the fund.

In simple terms2 a duration of 23 means that if market interest rates go up 1% then the fund loses roughly 23% of its value.

Equally, if interest rates fall by 1% then the fund would gain roughly 23%.

And here’s the rub – the average duration figure of every UK linker fund available to DIY investors (whether passive or active) is in this risky high-duration ballpark.

To give just one example: Vanguard’s UK Inflation-Linked Gilt Index Fund has a duration of 23. Fully 80% of its holdings mature beyond the next ten years and its longest dated security matures in 2068!

I’ll be quite mature myself by then and only a few years short of my birthday telegram from King William V.

But, hey, these funds have been fine so far because market interest rates have trended down since the early 1980s. The rate falls mean linkers have climbed in price, enabling the L&G All Stocks Index Linked Gilt Index Trust to smash the FTSE All-Share over the last 10 years – bringing home an annualised return of 8.7% for the linkers compared to just 5.5% for the shares.

But there comes a point… the world and his wife is waiting for interest rates to rise again…

And while the world and his wife may not be right, if they are right then big capital losses in long-dated linker funds could render their inflation protection moot.

Which is a bummer, because the point of your bond asset allocation is to offer stability, not volatility.

How far could rates rise?

First of all it’s important to mention that these ‘market interest rates’ I keep going on about are not the same thing as the interest rate set by the Bank Of England, which is known (in a rare instance of clarity) as Bank Rate.

Rather, market interest rates refer to the going yields on the whole universe of bonds across the yield curve, reflecting the returns that investors demand for bearing the risk of holding any particular bond.

Market interest rates are strongly influenced by Bank Rate, to be sure. But they are also influenced by the interaction of supply and demand, market expectations on the economic outlook, the credit worthiness of the bond issuer, any particular bond’s maturity date, and more besides.

In other words if the Bank Of England jacks its interest rate up by 1% over the next few years, that doesn’t mean your fund with a duration of 23 will automatically lose 23% of its value.

What actually matters is the prevailing real yield. This is the annual average return investors demand for holding any particular tranche of linkers after accounting for inflation. This is the market interest rate we’re concerned with here and it’s historically been much higher than it is now.

The graph below plots the real yield from linkers3 since they were introduced in 1981. It’s our best clue as to where we might expect yields from linkers to be in ‘normal times’.

UK real yield

Source: Sarasin & Partners Compendium of Investment 20th Edition, p.37

As you can see, the real yield hasn’t sat above 2% since the early 2000s. Since then it has drilled deep into negative territory. It was around -1% at the end of 2015, and it’s been even lower since.

A return to a 2% real yield on linkers would see the value of a typical long duration bond fund plummet. This is why the risk ratings in linker fund KIIDs4 are as high as for most equity funds, despite UK government bonds being seen as a safer assets class than shares.

But don’t just take my word for it – listen to someone with skin in the game. Paul Rayner who manages Royal London’s UK Index Linked Government Bond fund counsels:

If inflation gets out of control, the Bank of England would have to react by pushing base rates up sooner and faster, meaning real yields would have to go up more.

Because you are in the longest-dated bonds, the real yield move would have offset any protection you had from inflation. You would actually lose money.

Rayner actually believes that long duration UK linker funds are more suited to pension funds than retail investors:

We really stress this when we talk to investors in the fund. Most inflation products out there are not inflation-protected bond funds but real yield funds.

With 19 years of duration, the biggest driver [of fund returns] is what happens to real yield, not inflation.

Distorted market

So look, this all sounds pretty grim, and almost like anyone with a linker fund in their portfolio might as well be on a long-haul flight with a time bomb in their suitcase.

However there’s no certainty that real yields on UK linkers will head north anytime soon.

Why? Because UK pension funds are on an all-you-can-eat linker binge that shows no signs of abating.

I could quote any number of institutions on this topic, but here’s just one view from global bond specialist Pimco:

Put simply, it is the seemingly insatiable demand from UK pension schemes that has pushed valuations to extreme levels.

These schemes feel they have no choice but to accept ever lower yields as they seek to immunise their inflation-linked liabilities.

In short, regulation has forced UK pension funds to explicitly link their liabilities to inflation. Whereas previously the industry earned high returns from equities, the closure of many schemes and their diminishing time horizon has prompted a shift to larger inflation-linked gilt allocations in order to reduce risk.

The resultant demand from the pension industry for linkers far outstrips government supply. Hence their yields have continued to fall.

The pension funds care more about controlling their risk than generating strong returns. While regulation can change and inflation-focused derivative products have been introduced to ease the logjam, asset managers Schroders believe that yields are stuck fast:

Pension funds waiting for index-linked gilt yields to rise to ‘attractive’ levels are fighting a losing battle.

The imbalance is structural and yields are likely to remain depressed relative to economic fundamentals for the foreseeable future.

Tectonic forces are at work in the UK linker market. Real yields have never been lower but a rapid and one-way rebound is not inevitable. Even then yields would have to rise faster than expected to catch the market out.

What’s the answer?

Even if a bloodbath is not inevitable, it’s pretty obvious by now that long duration linker funds are not the anti-inflation defence most of us are looking for.

So where else can we turn for inflation protection?

Your options are to invest in:

  • Short-dated UK linker funds with shorter durations.
  • A ladder of individual linkers (i.e. not a fund) that you hold to maturity.
  • Real assets like property, gold, or commodities that are famed for their inflation deflecting powers.

Let’s deal with each of these in turn (as quickly as possible, because that 2068 bond is in danger of maturing before this post ends!)

Short-dated UK linker funds

I can’t find any of these in the active or passive space that are suitable for us DIY passive investors.

True, there’s the Dimensional Sterling Inflation Linked Intermediate Duration Fixed Income Fund – which has a duration of 9.6 – but that’s only available through a Dimensional-approved financial advisor.

There’s also a St James’ Place Index Linked Gilt Unit Trust that also looks like an intermediate fund (duration isn’t given). But, again, that one doesn’t seem to be available beyond an approved network of financial advisors. Oh, and its Ongoing Charge is an eye-watering 1.2%.

If anyone knows of anything more suitable then please let us know in the comments below.

A linker ladder

This strategy is called a ladder because you buy a series of individual linkers with maturity dates that match your future spending needs.

For example, if you estimate your spending to be around £25,000 in 2026 (seriously!) then you’d buy enough of the linker that will mature in that year to cover you when it pays out. That’d be Treasury 0.125% Index-Linked 2026, then.

The amount that you’ll actually receive will be adjusted in line with RPI. This is why linkers are so valuable to anyone exposed to inflation risk, such as retirees.

The point is by holding your linkers to maturity, you can safely ignore any intervening capital losses (or gains) caused by interest rate movements because you are guaranteed a known payout (plus the inflation rate) on maturity.

With a ladder, the inflation protection works as advertised, except that there are frequent two year and occasional three year gaps between available maturity dates. Calculating income requirements for three years worth of inflation is negligible at current levels, but it will be less so if the money-munching inflation monster is on the loose and it’s wearing a 1970s-style kipper tie.

You’ll also have to accept buying inflation-protection in the current climate means buying into a negative real yield. You will be losing a percentage point or two every year in order to immunise yourself against the threat of unbridled inflation in the future.

That’s not necessarily a terrible bargain given the havoc inflation can wreak – and anyway, you won’t escape negative yields by buying equivalent nominal bonds or funds either, given their current paltry payouts.

But obviously it’s not going to turn you into Bridlington’s answer to Warren Buffett.

Rolling short-term linkers

Another thing you can do with your maturing linker ladder is to reinvest it… in more linkers.

Let’s say you invest your inflation-linked allocation in index-linked gilts covering the next five years. As each linker pays out income and eventually matures, you reinvest the proceeds into new linkers that mature further down the line.

For example, when your index-linked bond 2017 matures, you reinvest the proceeds into the 2022 issue to keep the ladder extended out to five years.

This is known as a rolling ladder, and it’s effectively a DIY short-term bond fund. Your rolling ladder will have relatively limited exposure to capital losses (if you were forced to sell for some reason) thanks to the shorter duration. But it’s also a lot less convenient than a bond fund, as you have to manage it yourself.

I haven’t worked out the platform / dealing fee implications, so I’m not saying “Do this!” But it is an option worthy of further research if you’re interested. (Please do share your comments below if it’s a strategy you’ve investigated or implemented).

Other real assets

Gold, commodities, property, and equities are all touted as assets that can protect you against inflation.

But while there is some truth to the claims, there is plenty of evidence to suggest that none of the above are truly good inflation hedges.

For example, while equity returns have beaten inflation over the long-term, they can be severely damaged by high inflation conditions over shorter timeframes. (Think the 1970s again.)

The chart below shows that only the returns of commodities, timber, and short-term linkers correlate particularly well with inflation in periods of three years and under.

Assets vs inflation

Source: Global Inflation-Linked Products, Barclays Capital, p.227

Does that sound half promising? Well, the author of the table goes on to say that the volatility of commodity returns make them a poor inflation defender across any time period, and that the short data sample is a strike against timber.

This is but one of many commentaries I’ve read warning against investing in commodities. And there are plenty more still that lay waste to the notion that gold returns bear any resemblance to inflation.

On the other hand, investing grandees William Bernstein and Jeremy Grantham have written about the potential of precious metal and natural resource commodity producers to put up a stiff fight against inflation.

It’s a whole other post really, so for now you can read Grantham’s take and make your own mind up.

Shorter duration global inflation linked bond funds

Okay, now these look like a good option for accumulators, so long as the fund’s returns are hedged back to Sterling to eliminate currency risk from the equation.

Global inflation-linked funds invest in linkers from other developed world countries (not emerging markets) with the bulk coming from the US while the long tail is made up of France, Italy, Germany, Canada, Japan, the ANZACs and others.

The shorter durations of these funds mean less exposure to volatility should interest rates spike. The trick is to hold funds with a duration that matches or undershoots your time horizon.

Developed world inflation rates are related to each other (first cousins perhaps) but aren’t dead ringers. For instance here’s US CPI vs UK RPI over the last 50 years:

UK RPI vs US CPI

The two measures bear a resemblance, but UK RPI has been wilder at times. For this reason, if I was a retiree in need of precision inflation protection I’d think linker ladders first.

But as accumulators, most of us have time to ride out inflation – we’re more interested in diversification across asset classes.

In this scenario, global linkers can make a positive difference:

  • They have a relatively low correlation with other asset classes.
  • They offer a positive return but with less volatility than domestic linker bonds as interest rate movements across multiple markets mitigate financial shocks in any one country.
  • Higher inflation countries (hello UK) could benefit from a so-called ‘positive carry’ on the currency hedge, which could lower the mismatch in inflation rates over the medium term.

One among a number of sources extolling the virtues of global linkers is Barclays Capital. In its Global Inflation-Linked Products – A User’s Guide, the bank writes:

A currency-hedged global linker portfolio maintains the most attractive features of a domestic inflation-linked bond portfolio, specifically: better diversification, enhanced returns and low risk.

However, global inflation-linked bonds add a further diversification benefit to a portfolio, even if this already includes domestic inflation-linked bonds, leading us to see a global linker portfolio as the best way to capture the strategic benefits of owning linkers.

Both Tim Hale and Monevator’s own Lars Kroijer have global linkers on their list of acceptable assets, too.

Bear in mind that you shouldn’t have to pay tax on the inflation uplift received on income from index-linked gilts (assuming your fund is based in the UK). This is not the case for global linkers, so it could well be worth stashing them in your tax shelters.

There are a few Sterling hedged global inflation-linked products that are worth a look, although I have to say none look like my dream fund.

In the passive camp we have:

L&G Global Inflation Linked Bond Index I

  • OCF 0.27%
  • Duration – not given. Perhaps around 11 – 13? Contact L&G to find out for sure.
  • The fund holds 11% BBB rated linkers, which are below the UK’s AA- credit quality but still investment grade (just).

db X-trackers iBoxx Global Inflation Linked ETF

  • OCF 0.25%
  • Duration is 13.
  • The index is composed of 8% BBB rated linkers.
  • It’s a synthetic ETF.

Okay, well that’s the end of the passive contenders. With the choice is scarce so on this occasion – and with a clothes peg on my nose – I’m prepared to look over the active side of the fence:

Standard Life Investments Short Duration Global Index Linked Bond Fund

  • OCF 0.68% (Expensive!)
  • Duration not published – I judge around 9, but check.
  • Only 70% of holdings are actually inflation linked, 6% are corporate bonds, 2% are BBB.
  • 29% in UK bonds.
  • Active fund.

Royal London Short Duration Global Index Linked Bond Fund

  • OCF 0.33%
  • Duration is given as 5 in the brochure.
  • Only launched in February 2016 and info is scarce. There’s not so much as a factsheet available. I’d hold off until they reveal more.
  • 21% in UK bonds.
  • Active fund.

And that’s your lot, unless you know better? Again, please share your fund finds in the comments below.

Extra mature

Well, I don’t know about you but this post has certainly aged me. And if interest rates do jump up on those long-duration linker funds then I’ll probably add a few more grey hairs still.

How I wish the Government would release more NS&I index-linked certificates. They truly are the ideal antidote to the problem of inflation for small investors.

In the meantime, as a result of my latest research I now plan to pare back the allocation to linker funds in Monevator’s Slow & Steady portfolio to no more than 25% of its bond holdings. Perhaps less. I’m keeping them only as a diversifier as they are relatively uncorrelated with other asset classes.

The remainder of the linker asset allocation will go to a shorter duration global index-linked fund, which offers some inflation proofing and more diversification for the portfolio.

For retirees or near retirees, a linker ladder or inflation-linked annuity (as expensive as those options look) seem like a better bet. A small dose of commodity producer equities may warrant further investigation, if you can buy them cheaply.

Few areas in investing life are more important than inflation protection – I’m only sorry the options aren’t more comforting. As ever, we’ll just have to do the best we can.

Take it steady,

The Accumulator

  1. Government bonds are also known as gilts in the UK []
  2. Trust me, you probably don’t want the complex explanation. []
  3. Presumably a benchmark 10-year linker, but it’s not specified. []
  4. Key Investor Information Documents. []

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{ 94 comments… add one }
  • 1 Fremantle November 8, 2016, 10:34 am

    There certainly seems to be a gap in the market for short duration inflation linked government bond tracker funds.

    Fidelity have a Global Inflation-Linked Bond Fund Y-GBP (Hedged) with an effective duration less than 6 years and an OCF of 0.52%, but it is actively managed.

  • 2 old_eyes November 8, 2016, 10:59 am

    I am attracted by the idea of constructing a linker ladder with individual bonds, but every time I try and research how to actually do it, I seem to get lost in a forest of complex advice, rules and processes. Inflation protection is important as you start to spend your savings in retirement, but is as you say not easy to achieve.

    Any chance of The Accumulator or another poster providing an idiots guide to creating a linker ladder? Or at least pointing out to me the post where you have already explained all this.

    Please??

    old_eyes

  • 3 FI Warrior November 8, 2016, 1:40 pm

    I don’t know if it’s like asking for a unicorn, but couldn’t we try to think of totally novel, inflation-proofed investments here and now? We are living in extraordinary times after all, where technology is enabling things on a daily basis, that weren’t even conceivable just a little while ago. It cant be impossible, otherwise we’d still be living the same lifestyles as we did generations ago, whereas right now, kids couldn’t imagine that their own parents lived through the appearance of microwaves; never mind everyone’s mobile phones glued to their hand replacing ~20 incredibly helpful aspirational and recently individual devices.

  • 4 Jeff Beranek November 8, 2016, 2:06 pm

    I have previous experience with creating a UK linker bond ladder on the HSBC InvestDirect+ platform. Each time you buy or sell a bond it cost a painful £39.95, which works out at about 0.5% one-off charge on even a large portfolio of £40,000 assuming you hold to maturity – which you might not. Inflation will actually reduce the effect of the initial charge for long maturities (not including the annual platform fees of course). In my case I wasn’t trying to reduce the duration of the investment, but rather because (for reasons I won’t go into here) I was restricted from using funds and still wanted access to a lower correlation asset within a portfolio of directly held income-generating company shares. In the end, I sold all the bonds because they did so surprisingly well. The yield was as predicted but the capital values shot up. The long durations actually worked in my favour and I decided to get off the bus (bubble) whilst the going was good. It was supposed to be a safe, boring diversification, but it actually looked a lot riskier than planned. If I was to do it again I would probably use a conventional short-term gilt fund of up to 5 years, e.g. SPRD 1-5 Year Gilt ETF (0.15%), or a directly held bond ladder on a cheaper platform. I also hold the iShares US$ TIPS fund in my SIPP…

  • 5 Dave November 8, 2016, 2:19 pm

    I got in touch with L&G in 2014 to ask them about the average duration of holdings in the Global Inflation Linked Bond Index Fund, they responded that it was 8.20. Not sure if it would have changed since then?

  • 6 Vanguardfan November 8, 2016, 3:14 pm

    @old-eyes. I bought a couple of index linked gilts in an ISA I held with Alliance Trust Savings. Iirc, you just need to look up the list of available gilts on the Government Debt Management Office website (www.dmo.gov.uk) to decide which you want, and note its ISIN code. I then had to phone the broker to place the order, but was only charged the online dealing commission (£12.50 for ATS) – I’m sure dealing fee charges will vary by broker, so check with yours first. And viola! That was it.
    So, it’s not that difficult.

  • 7 dlp6666 November 8, 2016, 3:37 pm

    I was thinking of investing in IGIL (iShares III plc Barclays Capital Global Inflation-Linked Bond), where the factsheet indicates that duration is c.13, but am not sure if it is hedged to sterling.

    TER is 0.25%.

    Would this be ‘safer’ than the db x tracker ETF (in case Deutsche Bank were to collapse)?

  • 8 helfordpirate November 8, 2016, 4:30 pm

    Great article and a subject that I have been “worrying” about for many years – especially with the “what goes up must come down” feel about the stellar returns from linker funds in the last five years. Particularly good to see someone explain that the impact on bond funds is not the simplistic “1% rise in bank rates means loss of duration%” but depends on the interest demanded at that point in the curve and normal supply/demand issues which are massively distorted for linkers.

    Couple of other inflation protection thoughts…

    Short-dated UK inflation-linked corporate bond funds. There is an M&G one which is very expensive but has a duration of <2 (IFRC) and invests in a mix of government and high quality corporate bonds.

    Infrastructure funds e.g. SPDR Morningstar Multi-Asset Infrasructure ETF, invests in equity and bonds of utilities and infrastructure companies – bridges, Transport for London. Being highly regulated they often have income streams that are implicitly or sometimes explicitly linked to inflation,

    BTW I think the L&G Global fund actually tracks an "ex-UK" index, so that may risk too much on the correlation with non-UK bonds (especially if we continue to import inflation with a weak currency … don't go there).

    Obviously your focus was on explicit protection, but there is an argument a well diversified portfolio can provide protection through correlation with the causes of inflation. Cost-push inflation i.e. goods get more expensive through supply shocks or currency falls, via commodities and unhedged non-UK bonds. Demand-pull inflation i.e. more demand from more money in the economy either from improved productivity or monetary policy, UK-centric equities and UK bonds.

  • 9 tom_grlla November 8, 2016, 5:03 pm

    What an enormously useful column on a terrifying subject. Thank you.

    The iShares Global ETFs are not currency hedged, though personally I like it like that. Just for info, IGIL is US$ denominated and SGIL is sterling denominated. Neither seem especially liquid (I wonder if liquidity is another thing to consider for these sorts of things?).

    From memory Vanguard do a short-term TIP$ fund or ETF, but it doesn’t appear to have UK reporting status.

    Only other thing I can contribute is that TD Direct is the only platform I know of which allows you to buy I-L gilts directly (though who knows if this will change now they’ve been bought by iii).

  • 10 tom_grlla November 8, 2016, 5:07 pm

    Possibly it’s beyond the remit, but I’m going to mention the Capital Gearing Trust and Ruffer Investment Company, which both have large amounts of I-L investments, and from their commentaries have particularly positioned their portfolios to protect from inflation. I have absolute faith in CGT. RICA I waver on a little now that Ruffer is such a big organisation, but think they talk a lot of sense. Obviously this is not for hardcore passive types!

    Obviously not for hardcore Passive types though!

  • 11 The Investor November 8, 2016, 6:06 pm

    Just a quick note to say those that are interested can find more on Capital Gearing Trust in an article I wrote last year. (It doesn’t change much. 🙂 )

    http://monevator.com/capital-gearing-investment-trust/

    As Tom says, that’s a different beast though (you’re betting on a manager’s judgement and paying higher costs, though from memory not insane as far as active goes… but on the other hand an active fee is an even heavier burden in a low-yield world when a fund is mainly invested in expensive bonds, because the fees eat an even bigger proportion of your potential return).

  • 12 John November 8, 2016, 8:15 pm

    This is a very useful and important article on something that is not widely understood by investors. The key points – that index-linked gilts may do a very bad job of keeping up with inflation in the short term, and that almost all index-linked gilts guarantee a real loss of purchasing power over the longer term – are absolutely spot on.

    But it is confusing that the article takes a tangent from index-linked gilts into plain vanilla gilts (like the UK Gilt Treasury 4.5% 2034 you mention) and then talks a lot about interest rate risk. Compared to plain vanilla gilts and other fixed interest investments (fixed being the operative word), index-linked gilt prices are driven much less by (nominal) interest rate changes alone, simply because the coupons and maturity payment are not fixed at all.

    Instead, as coupons and maturity payments are linked to inflation, index-linked gilt prices are instead driven much more by changes to inflation expectations, and also the complex interaction between nominal interest rates and those inflation expectations (real interest rates). If nominal interest rates go up in reaction to higher inflation expectations, then that will have nothing like the impact on an the price of an index-linked gilt as it will on a plain vanilla gilt. You do get onto this, but all the talk beforehand of plain vanilla gilts and interest rate risk muddies the message I think.

    Of course, the point about duration still stands – regardless of what drives returns, long duration means that even small changes to those drivers of return can be amplified into very big changes in prices in the short term.

  • 13 The Investor November 8, 2016, 8:53 pm

    @John — Thanks for your thoughts, and the nice words. If mention of the plain vanilla gilt 4.5% 2035 is confusing that’s down to me; I inserted it as I wanted to explain as quickly as possible how gilts come in different maturities. I can’t recall why I used a nominal gilt as an example, now. Perhaps we should edit it.

    What drives the price of IL gilts, especially over the short-term, is as you say multifarious, and explaining it all perhaps a bit above our pay grade. 🙂 (We’re already up above 3,000 words here!)

    The key thing we wanted to get across though is that the rolling inflation up-rating is certainly not all that is changing the price, by a long shot. With some IL gilt funds up 25% in a year while inflation is running at a puny 1-2%, the disconnect is clear — and potentially liable to reverse. You’re right of course to say that many different factors work into this.

    We went back and forth a bit in the editing, with me trying to shoehorn in more explanation and @TA rightly wanting to simplify to make the article halfway readable to a retail investor (or indeed, just to us! 🙂 )

    For those who want a (little) bit more detail, this PDF by Royal London Asset Management might be an interesting read:

    http://www.rlam.co.uk/Documents-RLAM/Articles/ILG%20webinar%20note%201016.pdf

  • 14 John November 8, 2016, 9:18 pm

    @TI – thanks for the Royal London link, also a good read. Agreed this is above our pay grades: I don’t think many foresaw a 25% increase this time last year, given they already appeared ruinously priced for long-term investors even then! And now even more so – something very strange is going on when someone somewhere is buying with the intention of holding to maturity and paying a price to do so that locks in a loss of 2-3% per annum in real terms. You have to be pretty worried about high inflation (and/or the returns on other safe assets) to say, “you know what, inflation minus 2-3% per annum is my best option for the next few decades”.

  • 15 Andrew November 8, 2016, 9:22 pm

    Would holding short term bond funds such as IGLS UK Gilts 0-5 or IS15 Corporate 0-5 be an alternative? As these have a duration of appropriate 2.5 years, won’t they roll over into higher yielding gilts/bonds?

    The fidelity global inflation linked bond fund Y has a duration of 5.5 years which seems to be the lowest of the funds freely available. Has a fee of .51% though.

  • 16 Matt November 8, 2016, 9:31 pm

    Great article.

    One query though, is the duration risk not the same with regular bonds and linkers? You mentioned reducing your exposure to the linker fund but not the regular bond fund which suggests only the linkers are vulnerable. But if the average duration for these two funds is similar, then surely they both risk capital losses from higher interest rates?

    I think this is part of the point that John was making.

  • 17 Hariseldon November 8, 2016, 9:45 pm

    A possible but necessarily obvious investment is short dated gilts/investment grade bonds.
    In the event of sudden inflation, sharply higher interest rates is a probable response, by being short dated the hit will be quite small and the higher interest rates should feed in fairly quickly. Combined with a conventional equity portfolio, which eventually provides inflation protection albeit often with a lengthy lag, the short bonds provide spending money and capital in the short to near term.

  • 18 The Investor November 8, 2016, 9:52 pm

    @Matt — I should leave @TA to comment on his article when he gets a chance, but just quickly the regular Vanguard bond fund in the Slow and Steady portfolio has a duration of 12.3 years versus the index-linked fund’s much greater 23.1 year duration.

  • 19 dawn November 8, 2016, 9:55 pm

    very interesting post and something thats been concerning me with regards to my fixed interest allocation which currently sits in cash in an isa at a soon to end interest rate of 2.1%
    It comforted me alittle to read that neil woodford predicts inflation will spike in the short term and then settle down again.
    hope so.

  • 20 Matt November 8, 2016, 10:29 pm

    @Investor thanks for the reply. I had just finished going through the fact sheets, so realised the durations were different.

    I feel that the post seems to suggest that the issue is with the linkers, but in fact the bigger issue is the duration. I’ll read it again tomorrow, maybe I’ve missed something.

    I had a look at the Vanguard Lifestrategy funds and it appears they hold the bulk of their bond allocation in the Vanguard Global Bond Index GBP which has an even shorter duration at 6.8 years.

  • 21 pulpo November 8, 2016, 11:15 pm

    Excellent article, thanks.
    @Andrew Would holding short term bond funds such as IGLS UK Gilts 0-5 or IS15 Corporate 0-5 be an alternative?

    That’s all I do funnily enough. Tiny real return on IS15 last time I looked although IGLS is a powder dry job really. Plus ishare ERNS and NSI ILSC’s is about as sophisticated as I can get.

    Moving the goal posts on how pension funds calculate their deficits and which inflation measure they are required to target must be a concern to any IL holder too I imagine.

  • 22 Old_eyes November 9, 2016, 12:03 am

    @VanguardFan & @Jeff Braranek – thanks for the examples of how to invest directly in linkers. Something to look into.

  • 23 Jeff Beranek November 9, 2016, 1:24 am

    A few things to consider about holding bonds directly. Once you’ve bought the bond there are no ongoing charges (other than your platform fee). However, rebalancing is a little more complicated. Do you incur more fees to reduce or increase a current holding, or do you wait until you buy the “next rung” on the ladder? Charges matter even more than usual when yields are so low. I find conventional bonds easier to understand because you can calculate a yield to maturity. Note also that some linkers are bought and sold using ‘clean’ prices and some with ‘dirty’ prices (accrued interest included). Many websites don’t quote dirty prices, but you should see them on your platform or you can check Digital Look or Hargreaves Lansdown (good for bond data in general). I think some brokers require you to call them to purchase bonds directly, so you may be charged the telephone transaction fee. I wouldn’t recommend holding them outside a tax wrapper, especially if you are ever likely to be a higher rate tax payer with a tax-free savings allowance of just £500. Also it saves you having to report your interest and accrued interest receipts to HMRC. I’ve often considered the practicality of implementing the Permanent Portfolio (25% each of shares, gold, short gilts and long gilts) using direct bond holdings, but in the end I think you would be better off using ETFs or funds.

  • 24 Mroptimistic November 9, 2016, 8:49 am

    I hold a fair chunk of IL 2024 2.5% in an Alliance Trust and Halifax ISA. With Halifax had to be a phone deal however don’t recall either being particularly expensive. Mind you this was more than a 15 years ago when 2024 seemed a long way off. Since the demand is from insurance companies and pension funds the emphasis will be on durations matching the duration of their liabilities, hence don’t expect a short duration IL anytime soon. I can’t see any argument which supports buying these certain loss making investments at current prices, directly or via a fund. I am only a couple of years away from retirement and a burst of inflation would be ruinous. The best defence can only be diversification. Note that high UK inflation means weak sterling and high domestic interest rates so convention ones are destroyed. Global inflation means ……dunno. Invest in commodities I guess.

    However, don’t forget that the global economies are slightly
    not exactly steaming ahead. Problems in China could put deflation fears back on the map.

    So diversify and pray!

  • 25 dlp6666 November 9, 2016, 11:05 am

    I much like the sound of the short duration of that Fidelity fund, but it seems that Morningstar’s view on the fund is only lukewarm:

    “Overall, Foster’s limited experience in the inflation-linked space combined with his wide-ranging responsibilities, recent tweaks to the approach, and the fund’s poor showing since 2011 give us pause for thought. Our current view is best reflected by our Morningstar Analyst Rating of Neutral”

  • 26 Mroptimistic November 9, 2016, 12:45 pm

    Personal Assets Trust is a defensive holding which hold IL and gold. Charges aren’t low though.

  • 27 Lewis November 9, 2016, 4:36 pm

    The reason that you won’t find a UK short term index linked gilt tracker is because there are so few UK short term index kinked gilts (See http://www.dmo.gov.uk/reportView.aspx?rptCode=D1D&rptName=47105130&reportpage=D1D). There are only five with a duration of 10 years or less and only two with a duration of 5 years or less. For the same reason, it wouldn’t be possible to create a UK index linked bond ladder, without a lot of rungs missing.

  • 28 Lewis November 9, 2016, 4:47 pm

    Another active fund to consider is M&G UK Inflation Linked Corporate Bond, its objective is:

    “to provide a level of protection from the effects of inflation by generating a total return (the combination of income and growth of capital) consistent with or greater than the rate of UK inflation over a rolling three- to five-year period. There is no guarantee that the fund will achieve its objective over this, or any other, period.”

  • 29 Matt November 9, 2016, 4:57 pm

    The more I think about this article, the less of a problem I see. I would argue that our standard line of defence against inflation is not Index-Linked government bonds as suggested, but is actually our diversified stock portfolio. The linkers only protect the coupons from inflation not the entire portfolio. During periods of high inflation we would expect the stocks to perform well.

    Yes the Index-linked fund is more susceptible to interest rate risk than the regular bond fund, but not by the nature of it being a linker, it’s because the average duration is longer. For this longer duration we are receiving slightly higher returns and accept slightly more volatility. We would expect bond prices to fall during a hiking cycle. As long as the duration is within the target horizon of the portfolio then I don’t really see a problem.

    Please feel free to correct me, I do feel as though I’m missing something.

  • 30 Mroptimistic November 9, 2016, 6:11 pm

    My wife holds funds in M&G including the Inflation linked Corporate Bond fund and Global Floating Rate High Yield fund. They aren’t cheap and we are looking to shift away from M&G. Been with them since PEP days when the choice was as now and ETFs didn’t exist. M&G seem intransigent on fees, no discounts on any platform I’ve seen.

  • 31 The Accumulator November 9, 2016, 7:46 pm

    @ Fremantle / Andrew – yes, I should have included that Fidelity fund. Its duration is only 5 although there were several things I didn’t like about it including a mandate to invest in nominal and corporate bonds and short positions.

    @ Matt – If you’re referring to the Slow & Steady portfolio then I’m fine with the regular bond fund as its duration is below the portfolio’s time horizon. Also, the intermediate fund will perform better than a short fund during a crash. Also, also 😉 I was trying to stick to linkers in this piece because the only linker funds you can buy are long duration.
    I agree it’s best to avoid durations that are longer than your time horizon with all bond funds but, in the case of linker funds, your time horizon needs to be under 20-something years. And closer to 50 if real yields were to rise by 2%.
    Linkers protect your principal too, not just your coupons. Equities tend to do well in moderate inflation conditions but do badly when the expectation is unexpected. Equities do well against inflation in the long-term but the lag can be lengthy. Not a problem if you’re a young investor but a live issue if you’re not-so-young.

    @ Andrew / Hariseldon – short nominal bond funds will recover quite quickly from a rise in interest rates but the research I’ve read says they do badly in unexpected inflation scenarios.

    @ dlp – if the factsheet doesn’t make clear it’s hedged to Sterling then it’s not.

    @ Mr Optimistic – you just made the argument for taking the negative yield on linkers: “I am only a couple of years away from retirement and a burst of inflation would be ruinous.” Many are prepared to take a guaranteed but relatively small loss to avoid the prospect of a ruinous one. Granted, it’s an unsavoury choice.

    @ America – OMFG!

  • 32 Matt November 9, 2016, 8:43 pm

    @ Accumulator – thanks for the lengthy reply, makes a lot of sense. 🙂

    I’m a little confused by “…in the case of linker funds, your time horizon needs to be under 20-something years. And closer to 50 if real yields were to rise by 2%.”

    Should this read “over 20-something years.”?

  • 33 SemiPassive November 10, 2016, 9:51 am

    On the subject of buying individual gilt issues, can anyone point out the simplest way to calulate what the approx real loss pa will be on, say a 2026 index linked gilt (based on figures available on Hargreaves Lansdown price sheet) and how it compares to, lets say a 2026 conventional gilt with gross yield to redemption of 1.5%?
    E.g at what rate of RPI does the index linked gilt outperform bearing its already daft market price in mind?

  • 34 Jeff Beranek November 10, 2016, 10:23 am

    @SemiPassive – I gave up trying to calculate a predicted yield or total return and was satisfied just keep track of historical performance. However, you get bond data from Fixed Income Investor: http://www.fixedincomeinvestor.co.uk/x/bondtable.html?groupid=3530

    Their figures are based on an assumed rate of RPI inflation of 3% (because the bonds are RPI linked) whereas the the Bank of England is targeting CPI of 2% for the economy.

    The site has lots of info about bonds here:

    http://www.fixedincomeinvestor.co.uk/x/learnaboutbonds.html

    Inflation-linked bonds and pricing methods are discussed here:

    http://www.fixedincomeinvestor.co.uk/x/learnaboutbonds.html?id=206

  • 35 Mroptimistic November 10, 2016, 10:49 am

    Ah yes, thanks for the reply. The trouble is what is an appropriate premium to pay to hedge against the risk of inflation above 5% for a significant period. I was around and paying attention during the 1970’s with the oil shocks, 3 day week, IMF bailouts, stagflation. It has coloured my outlook on investing ever since I started having money left to save with. People currently who take an ‘inflation linked’ annuity or pension where this link is only good to a 5% cap need to be aware of the risk. I wonder if a future misselling scandal will emerge if this happens and those stuck with severely diminished lifetime income shout betrayal. Thanks again.

  • 36 Fremantle November 10, 2016, 10:58 am

    @TA

    I don’t particular like Fidelity’s short duration inflation linked bond fund either, costs are two high and tracking is awful, not to mention the corporate and short position pollution.

    New products required, look at this for our US friends…

    http://www.morningstar.com/funds/XNAS/VTIPX/quote.html

  • 37 Mroptimistic November 10, 2016, 11:12 am

    @semipassive. There are web sites which help with pricing IL bonds however the Saturday FT has the calculated real returns for selected issues, though you have to look quite hard to find it. However if the predicted real return is -1.5% against an inflation assumption of 5% ( as per the FT table) then simple minded me turns this into an annual return, including redemption, of 3.5% in nominal terms. The real returns of course -1.5% pa. The basis of the blog is that unpalatable as this may be, it might be very good in terms of the alternative outcomes. However this is a pessimistic scenario and the question is what risk probability would you put on it to guide your asset allocation. A further complication I struggle with is that high inflation in the past has met with aggressive interest rate rises as the Central Bank realises it is badly behind the curve. In the past this was always due to ‘wage price spiral’ or money supply excesses. We had more recent experience with this in the early 1990’s when it all went t*ts up with the ‘snake’. I will see if I can find anything which measures IL performance then.

  • 38 Mroptimistic November 10, 2016, 11:19 am
  • 39 SemiPassive November 10, 2016, 11:57 am

    Thanks Mr Optimistic, that is really useful. And thanks for the article TA.
    So at the moment 3% RPI seems to be a rough tipping point in favour of linkers over the next 10 yrs vs regular gilts. It will shoot way over 3% RPI next year of course, but how sustained it is over the rest of the next decade is anyone’s guess.

    Btw the 10 year horizon is relevant to me as it is when I can take my 25% lump sum from SIPP, so preferable taking it from bonds that have just been redeemed rather than selling down equities that may be in a bear market at the time.

  • 40 Mroptimistic November 10, 2016, 12:02 pm

    Sorry, just saw someone has already provided that link.

  • 41 magneto November 10, 2016, 12:04 pm

    @TA
    Excellent review of this challenging subject.
    Many thanks.

    “If you’re referring to the Slow & Steady portfolio then I’m fine with the regular bond fund as its duration is below the portfolio’s time horizon” TA

    Would it be possible to be possible to expand or link on the time horizon aspect, in terms of whether with our Fixed Income we are aiming beyond retirement or other?
    Thanks again.

  • 42 Grumpy Old Paul November 10, 2016, 12:09 pm

    All too complicated for me. Using a mix of Vanguard Life Strategy 20%, Vanguard Global Bond Index Hedged and the Vanguard Inflation-Linked Index fund. I take into account the 20% equity exposure of the LS 20% in my overall balance and I have periodically sold off the Index-Linkers to keep the portfolio asset allocation stable. I also have a tranche of NS Index-linked certificates which I started accumulating in the late 1980s when they paid RPI+4% (!).

    The Index linked stuff is there as protection against high inflation – I remember when it was 26% in the early 1970s and 20% in 1980. As observed above, they are also a good diversifier.

    I may look at Global Index linkers but the VF LS 20% gives me a bit of that, it’s cheap and I don’t have to worry about it. I agree with the Accumulator’s points about Global Index linkers but would point out that a Global Equity fund would also give a measure of protection against home-grown inflation via currency depreciation as well as capital/income growth.

  • 43 Mroptimistic November 10, 2016, 2:36 pm

    @magneto. My perspective is narrow owing to imminent retirement and balancing the peculiarities of db pensions against other pension assets. This causes a short term focus but in the end I still need to be invested for the (hopefully) long term after that. This blog is I think mainly aimed at building wealth and how best to ride out the inevitable ups and downs. From what I can see if I was 40 again I would be in cash and equities, not bonds or IL, figuring on keeping employed and riding it out. The real casualties of recession are those whole lose their jobs. If you stay employed a bit of inflation is not to be feared. However, relying on an income from investments after retirement is a whole different game, especially if inflation prospects are worsening.

  • 44 The Accumulator November 10, 2016, 7:50 pm

    @ Matt & Magneto – it’s a confusing topic and really deserves a piece of its own.

    The standard advice is to match your duration with your time horizon. (Duration could apply to a bond fund, a bond, or a portfolio of bonds). The idea being that your bond portfolio will have recovered a loss in value if you hold it for the duration.

    However, that advice isn’t a whole lot of cop for someone who doesn’t know exactly what their time horizon is. (Magneto – The Slow & Steady portfolio will have 14 years left this Jan but that’s only because I arbitrarily set it at 20 years originally.)

    The reality is that an accumulator’s portfolio becomes a retiree’s portfolio after the happy day and a retiree doesn’t know the length of their time horizon with any precision. At least until home genetic testing tells us when we can expect to meet our maker.

    So, Magneto, to try and answer your question, your time horizon does transition into retirement. But, because you’ll be withdrawing in this phase, you may prefer a rolling ladder of bonds for absolute control or settle for a short-term bond fund to balance convenience and volatility.

    Matt – forget that comment about 50 years – I’m even confusing myself. In the case of bond tracker funds, the duration is held roughly steady. If the average real yield of the linker fund goes up 1% then you lose 23% but will recover it in 23 years (assuming duration is 23 and no further change in interest rates). However, in a rising rate environment, that duration effect will keep resetting. So if the real yield goes up another 1% in 5 years time then you’re looking at another 23 years on top to recover. This assumes that interest rates don’t move around in the meantime, which they will, so it’s a pretty artificial concept. The bottom line though is that a long bond fund will be a very tough place to be in a rising rate environment. If that ever happens.

  • 45 Atlantic November 11, 2016, 11:16 am

    I have deliberately avoided Irish domiciled funds such as the VanguardU.K. Government Bond Index Fund as I’m not sure how they will be affected when/if we leave the EU.
    Does anyone else have a view on this?

  • 46 hutman November 11, 2016, 11:48 am

    Can this be summarized in a few bullets pls?

  • 47 matiarchus November 11, 2016, 9:09 pm

    Forget about bonds (if you can). Why buy a 5 year gilt yielding 0.64% as of this date when 5 year cash isas are available yielding 1.45%? Alternatively, for outside ISA money you can get 2% on five year fixed rate deposits (although you lose the liquidity). These days you may get an extra 1% yield from quality corporate bonds, but is it really worth it? As for index linkers – forget it. They have been driven so high in price it is ridiculous, frankly.
    Only invest in govt bonds if you have no other choice (often the case with pensions). Oooh – don’t get me started on the pension industry. The pension industry really needs to sort out better arrangements for fixed rate cash deposits within pensions. Why must we pay exorbitant charges for a fancy flexible SIPPS to gain options beyond capital markets-based funds? Funny, isn’t it how the only options for most savers are highly liquid investments, when they have no need for the liquidity whatsoever…..
    Why is cash outside of a pension (or even an ISA) not able to find its way into a decent fixed rate bank deposit? The FS industry really should look at this – you just don’t need the liquidity of bonds within a long term wrapper like a pension.
    Hopefully peer to peer will eventually mix up the whole situation…..

  • 48 mroptimistic November 11, 2016, 9:38 pm

    @hutman. No, not generally. It depends on your objectives and how much risk you can afford to take. The first thing is to decide what you cannot afford to happen and to make sure you are protected from that. This has no general answer. I am 63 and have no debt. If you are 35 with children and a mortgage your answer will be different. Note the tenor if these discussions which is generally that we are in a temporary abberated market and stuff, eg IL bonds, is mispriced. So us clever folk think we know better than the market! Perhaps read Lars book? But if in doubt cash is a risk free asset, but an unproductive one, assuming you are agile enough if inflation marches up the road.

  • 49 StevieD November 12, 2016, 5:36 pm

    The fund I think you might for inflation protection is the M&G UK Inflation-linked Corporate Bond Fund (actually these days it seems to have more government paper than corporates, despite the name). Its duration has been kept very short, precisely with the intention of reflecting inflation outcomes not real yield expectations.

    PS Ironically, I wrote to several fund houses a year ago asking them to build a simple very lowcost short-duration index-linked gilt tracker. They all said they could not see higher inflation on the horizon. Drrr.

  • 50 Jeff Beranek November 12, 2016, 6:01 pm

    @Atlantic – Although this is getting off-topic… all of my ETFs are domiciled in Ireland (iShares and Vanguard) or Luxembourg and I don’t have any problems with that. It’s up to the UK if they want to accept European domiciled funds and I can’t imagine why they would want to reject them, especially from the incumbent issuers (of which Vanguard and iShares are probably the largest). Besides, most of the major funds are already listed on multiple other European exchanges so I don’t see why the UK would want to shoot themselves in the foot and disallow them from London. Here are a couple of interesting articles on the issue:

    http://www.investorschronicle.co.uk/2016/05/19/funds-and-etfs/etfs/brexit-could-take-toll-on-london-etfs-gnEiTtSxlP5bq9sdos43hL/article.html

    http://www.ft.com/cms/s/0/8a62a78e-8637-11e6-8897-2359a58ac7a5.html?ft_site=falcon&desktop=true

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