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

Rampant inflation [1] is Public Enemy No 1 for most investors. (That is assuming you’ve already got yourself [2] and the active fund industry behind bars).

Our standard defence? Index-linked government bonds [3] – affectionately known as ‘linkers’ in the UK.

Linkers are a special type of government bond1 [4] 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 [5] 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 [6].

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 [7].

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 [8].

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 [9] 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 [10] 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 [11] 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 [12] 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 [13], 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 [7]. 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 [14] 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 [15]

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 [16] 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 [17]:

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 [18] 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 [19] 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:

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 [21]

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 [22] 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 [23] 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 [24]

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:

One among a number of sources extolling the virtues of global linkers is Barclays Capital [25]. 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 [26] and Monevator’s own Lars Kroijer [27] 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 [28] 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

db X-trackers iBoxx Global Inflation Linked 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

Royal London Short Duration Global Index Linked Bond 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 [30]. 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 [31] 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 [34] in the UK [ [35]]
  2. Trust me, you probably don’t want the complex explanation [36]. [ [37]]
  3. Presumably a benchmark 10-year linker, but it’s not specified. [ [38]]
  4. Key Investor Information Documents. [ [39]]