Is it time to ditch index-linked bond funds? [Members]
For MAVENS and MOGULS by The Accumulator
on June 11, 2024
Index-linked bond funds were meant to protect us from surging inflation, yet they failed their first serious test. Since CPI took off at the tail end of 2021, these products have been a bitter disappointment – like waterproof trousers that leak or wasp repellent that attracts the blighters like it’s made of sex pheromones.
We’ve previously explained exactly why index-linked bond funds didn’t work during the car crash markets of 2022.
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Also the tax free nature of capital gains on individual gilts is handy, plenty of low coupon issues from the low rate era
I think the main driver of gold over the period was government buying in response to US sanctions on Russia (governments not on America’s Christmas card list that is), when they froze Russia’s dollar denominated reserves it triggered big flows out of Treasuries and into stuff Uncle Sam can’t confiscate, mainly gold. Very unusual for real US rates and gold to rise together, as they have
Perhaps I’ve misunderstood, but isn’t there another way in which index-linked bond funds are better than nominal funds in this scenario?
The rising discount rate may have reduced the price at which they currently sell, but the underlying cash flows and maturity values of the index-linked bonds have been protected from inflation, which means the bonds will recover if held long enough.
Nominal bonds on the other hand, have genuinely had their cash flows and maturity values eroded by unanticipated inflation.
Which I suppose is why you’re saying hold individual bonds instead because you can hold them to maturity. But isn’t continuing to hold the fund *somewhat* like holding to maturity – issues of rolling over bonds aside?
There’s always the danger of fighting the last war I suppose.
Since I am retired I want to dampen risk, so if bond funds can’t do that in an inflationary environment it gives me a problem. No one says commodities are low risk.
My only thought is perhaps high yield bonds.
I might buy an individual linker or two, to sit alongside my NS&I certificates.
Is AJ Bell the only broker that provides accurate valuations for linker holdings? I dislike the idea of not being able to see the true value.
Agree, gilts are giving effective rates of 7% (for a 40% tax payer) and are an easy pick atm. With the index linked break even inflation rate about 3.5% the safety of a linker seems to be quite costly to me. Obviously politics is a best rather volatile and is likely to have a big impact on inflation so I think a commodities basket or real assets (land) is quite a safe bet (at least it offers some diversity). Overall what has happened with interest rates is not really a surprise and we do occasionally get bursts of inflation but the general trends for both in a reasonable political climate will imho be steady or more likely downwards from where they are today. Of course we all know what can happen when the crowds vote for strategically economically naive policies, fingers crossed that’s it for a few decades now.
@tetromino
You can get accurate data for individual gilts at tradeweb. Creating an account is free.
https://reports.tradeweb.com/account/login/?ReturnUrl=%2f
Or use a trend/managed futures fund which picked up the move in commodities/ fall in bond prices and gave a similar performance to the commodities fund (but tends to be less volatile overall)?
Brilliant article as ever. Thank you @TA. FWIW (not advice nor a recommendation) my own preferences are:
Within tax shelters (ISA or SIPP): Broad commodities ETFs, Gold ETFs, Trend Following / Managed Futures funds, exchange listed macro hedge funds and intermediate duration TIPS ETFs (the $ often appreciating in an equity crash). I won’t bet on any one horse here. It’d be across all 5 with similar allocations.
Outside tax shelters (i e. for any funds available which are not needed immediately and which exceed the ISA and SIPP annual allowances): individual Index Linked Gilts carrying low coupons (so secondary market purchases here, as the fresh Debt Management Office issues now carry larger, taxable, coupons) and each one then held to maturity.
In January 2021 bonds yields both nominal and real yield inflation linked were very low.
Negative real yields on inflation linked bonds meant you were never going to get a real yield, unless interest rates became even more negative. Before buying a fund it’s worth looking at what’s inside.
For example last year I bought March 2026 0.125% linker for a clean price of 98.4 pence , it will mature at £1 in March 2026, plus a inflation linking , it’s gained 4.5% in the last 12 months.
The same bond was trading at a clean price of £1.23 in October 2019, you would have received a very small interest rate and full inflation protection but you were guaranteed to lose 19% in real terms over 6 1/2 years.
The other side of the coin is the index price, has risen £1.12 to £1.465 to date.
Out of interest if you had bought a short dated Index Linked Bond at par in March 2021 and sold it March 2024 you would have received a 29% return.
So there is no fundamental problem with index linked bonds , but it really, really matters the price you pay…
Now that prices have fallen and real yields are positive on index linked bonds they are a more attractive purchase now.
By the way Dimensional offer a £ 5-15 year inflation linked bond fund. Neither ii and HL are yet offering the ishares 1-10 linkers fund.
@Hariseldon #7: you’ve hit the nail on the head.
You can’t be completely passive with index linked – you have, to some degree, to exercise a judgment on price – e.g. not to pay up for a negative yield to maturity. With equities you can argue for the wisdom of the crowd because price embeds future expectations of earnings growth alongside everything else (e.g. future path of interest rates for discounting earnings). But bonds is ultimately maths. The linker maths is complex, but buying above par on the clean price guarantees (at least I think I understand) a loss if held onto until maturity.
I should have added to my previous comment that I intend to get exposure to conventional US Treasury Bonds (via the WTEF capital efficient/return stacked ETF, which gives 60% intermediate duration US Treasury Bill exposure via futures, alongside a 90% replication of the S&P 500 on the equity side – i.e. 1.5x leverage a 60/40).
So it’s not just TIPS, but also conventional US Treasuries, that I’d intend to try to use to buffer the equity exposure.
@Mousecatcher007
Thanks, but it’s an accurate account valuation that I’m looking for. I dislike the idea of having an account balance displayed using the clean price rather than the dirty one
I saw from past comments on an FT article that AJ Bell is one of the few (only?) places that gets it right.
I have been using a shorter TIPS GBP hedged ETF (TI5G) as a proxy, which produced somewhat better results than the UK linker ETF. Still not stellar but noteworthy, I think.
@Deltahedge
I saw this 90/10 – 90/60 WTEF fund mentioned late last year.
Thee is a discussion here on the original US product. https://seekingalpha.com/article/4543742-examining-ntsx-as-a-substitute-for-spy-maybe
I would be concerned that such a product might offer a very modest advantage most of the time, but be subject a significant risk in ‘bad’ times.
I came across an interesting comparison between US Corporate bonds and a 90:10 US Treasuries : US Equities, overall returns very similar but in the bad times the blend declines less.
There is an argument that all you need is the risk element , broad equities and the risk free element , just play with the allocation
@Paul (#3) – you may want to re-consider if HY bonds are right for you. The high yield is due to higher risk, and being risk assets, they are more correlated with stocks. That’s why I avoid HY bonds and investment-grade corporates too. I’d rather increase the proportion of stocks slightly, and keep the defensive part as uncorrelated as possible.
Many thanks @Hariseldon #12.
Quite concerning to see the stark SA ratings disparity between NTSX and SPY, but also somewhat reassuring that NTSX did manage to reduce the SPY 19.6% fall in the March 2020 teeth of the Covid crash to a 14.4% one and that, notwithstanding the appalling bond crash of 2021-22, as of Oct 2022 its Sharpe ratio was still only a smidgen lower overall than for SPY.
I suspect WisdomTree’s argument (per that put forward by sites like Optimized Portfolio) would be that using NTSX/WTEF synthetically gives the conventional bond exposure via the use of futures, and therefore avoids any need to allocate capital separately to conventional bonds.
So, they might argue that one should instead compare either 100 SPY or 60/40 SPY/conventional Treasuries to an allocation of 60 NTSX with 10 each of broad commodities, gold, trend following and TIPS. Optimized Portfolio do something a bit like that here, albeit with a slightly different mix for the 40 part:
https://www.optimizedportfolio.com/ntsx/
Great article and a timely reminder that I need to wrap my head around linker funds. According to Scott Cederburg, who I believe is a credible source, linkers are the correct risk-free asset for long-term investors (this is from a Rational Reminder podcast). But why have linker funds done so badly in 2022 when they were supposed to shine? Is it just duration; or is there a problem with the constant-maturity rolling that makes the fund structure fundamentally unsuitable for linkers?
Maybe GISG is still too long duration (currently 5.0 years) and a lopsided comparison with IGLS (2.2 years) during a period when duration was the one thing to avoid. I need to look further into some shorter-duration linker or TIPS funds.
In any case I’m with @TA, @Delta Hedge and others here that proper diversification requires more than bonds. Commodities, gold and cash all have their place, as do trend following and macro hedge funds imo.
@ Laurence M – Imagine if you held an allocation of short nominal bonds and short linker bonds, and the only difference between them is the linker bond’s inflation-adjusted cashflows. The nominal bonds’ yield includes an inflation premium. If inflation is lower than market expectations then the nominal bonds will beat the linkers. If inflation is higher than market expectations (i.e. the inflationary component of the nominal bonds yield proves inadequate) then the linkers win.
If the market continually overestimates inflation then nominal bonds are the place to be (as happened post-1970s). Nominal bonds have provided a real return over time, so they can recover from inflation, too.
There is no difference between holding a portfolio of bonds in a fund versus holding a portfolio of identical individual bonds, so long as they’re treated the same. However, funds sell their bonds before maturity whereas an individual can hold them to maturity.
The new target maturity bond ETFs could solve the problem so long as they hold the right assets.
@ Paul a38 – Commodities aren’t low risk in isolation but historically they’ve helped lowered overall portfolio risk due to their negative correlation with bonds and equities:
https://monevator.com/commodities-diversification/
Gold has had a similar effect:
https://monevator.com/does-gold-improve-portfolios/
@ ChuckieB – got any recommendations? What are the potential downsides of that approach?
@ Delta Hedge – Why not a long US Treasuries fund for crash protection? Re: negative yields, I’d argue it’s rational to accept them up to a point to immunise against inflation – if loss of purchasing power is a major threat to you as an investor e.g. retirees.
@ Hariseldon – Agreed, buying at a negative yield-to-maturity meant taking a loss. But many investors were prepared to accept that on the understanding that the product would hedge inflation. The profitability of the asset is one thing, but the USP for linkers is inflation-hedging, and the fund versions failed on that count.
Is there some way of accessing the Dimensional fund without going through an advisor?
@ Sparschwein – there isn’t anything shorter AFAIK. I looked at Royal London’s Short Global Linker fund, which is slightly shorter, but the result was much the same. If I’d held a portfolio of individual linkers of whatever duration in 2022, my broker’s dashboard would have shown falling prices but I can ignore that so long as I’m holding to maturity. Meanwhile, the funds are selling to maintain maturity so crystallising the losses. Over time, the new higher yielding bonds purchased by the fund can make good the loss but I bought them to hedge inflation.
@TA, Hariseldon
There’s nothing special about the Dimensional fund, as far as I can see? If TA is miffed that the swing in the real yield outweighed the index linking then I suspect the iShares up to 10 years or the similar Capital Gearing fund are better options, given their shorter durations.
@TA @Tetromino
The Dimensional fund can be bought on ii, (with a few other Dimensional funds without advice) as I recollect I couldn’t do so online but phoned and dealt at the same price.
The Dimensional funds duration fitted well with my portfolio and individual Gilt and linker holdings. No secret sauce !
@TA #17: yes, long duration for max crash and deflation/falling rates protection, but necessarily at the risk of worse outcomes in rising rates/ high inflation/reflation scenarios.
Also, AFAIK, if one were to go the return stacking/capital efficient route with WTEF ETF here in the UK (and likewise, I think, for the broader suite of the RSSB, RSBT, NTSI and NTSE ETFs available in the US) then the US Treasury bond replication is of blended/mixed duration, so roughly equivalent to intermediate duration. So, there’s no chance of going long only there with bond duration, you have to take what you’re given. However, when you’re effectively leveraged (1.5x, as with WTEF) the extra volatility of a longer duration for the bonds is perhaps more of a risk than an advantage beyond a certain point.
Personally, I’d be adverse to paying up for anything on negative YTM in either the fixed rate conventional or inflation linked bond world.
I recall that at one point in the 2010s some Swiss Government Bonds of one duration or another (can’t remember which now) got to a minus 4.5% p.a. YTM. I think that you’d have to be a very high conviction believer in the strongest version of the EMH (i e. market prices are always right) to pay up for that.
For myself I accept as working hypothesis the weak version of the EMH, namely that market prices reflect all public info. and are likely a better guess at fair value (having regard to all circumstances and the different interests at play of all buyers and sellers) than both the average and median competency level individual market participant.
As I believe that I’m of less than average or median competence in identifying and exploiting market price anomalies/errors the price has to be pretty blatantly way out of whack before I’ll take a different view to the market cap weight one. When you effectively pay to lend to someone (as with buying bonds on negative rates) that point may have been reached.
So, as an extreme example, a minus 4.5% p.a. YTM would, IMO, be such a clear instance where I would take a different view and avoid with a bargepole.
@Delta Hedge
Interesting thoughts
On a semi related note what do you make of the negative carry on the bond futures in the return stacked / capital efficient funds?
I’m no expert but understood the futures price is the yield on the underlying bonds less an overnight repo rate so an inverted yield curve means a negative carry
Personally I like the return stacked concept and was thinking about implementing it but, a bit like negative real yields on linkers pre 2022, I’m struggling a bit with a leveraged bond allocation with higher financing costs than yield. Perhaps I’m missing the point though
Hi @AoI #21. Spotted your query on negative carry on the Moguls’ Leveraged ETF Finumus’ piece thread yesterday and thought that it was an excellent question. Sadly, as a non expert, it’s one that I don’t know the answer to.
Obviously, however, when the actual or implied cost of borrowing v. significantly exceeds the yield of the security – as in a negative carry – then, prima facie, that’s bad.
On the other hand, maybe for an active investor it could be a contrarian indicator, i.e. yes it is bad now, but might that not perhaps indicate that the time is getting closer when the yield curve goes from inverted to upward sloping and in doing so the leverage goes from a negative to a positive carry situation?
Some series like volatility are very strongly mean reverting so extremely high volatility (VIX/VIXN >50) is very rarely if ever followed by higher volatility, and overwhelmingly tends to fall off. I don’t know what the pattern is for yield curve inversions though, or even if there is one.
This is what Jupiter Asset Management have to say on the subject (on 30/4/24):
“owning longer-dated bonds continue[s] to be tricky as investors will effectively earn a negative carry from day one as cash provides better returns than coupon yields on government bonds. Therefore, we’ve had a bearish slant to rates in recent times. This has induced a tension in the bond markets and created volatility as a gap still exists between where the rates are and where they are expected to be. This might remain until a rate cut happens and the future path becomes clear. Even if investors wanted to go long bonds, the negative carry is deterring them from making any bold moves. Right now, the market is stuck in a no man’s land. We believe a catalyst is needed to make the market more bullish.”
@Hariseldon
Thanks for confirming re. Dimensional 5 to 15
In case it’s helpful to anyone, here’s an ‘up to 5 year’ fund from L&G, just to illustrate how a fund like this would have performed recently. Not available to us, unfortunately. The various FTSE Russell linker indices are also educational.
That L&G fund: https://fundcentres.lgim.com/en/uk/institutional/fund-centre/PMC/Under-5-Year-Index-Linked-Gilts-Index-Fund/
@ Hariseldon – I wonder if Dimensional will close down that avenue when they realise? I bought a couple of DFA funds on AJ Bell some years back. Next thing I knew they were no longer available. I spoke to a DFA guy who very firmly told me that you could only buy through an advisor. My guess is that occasionally a fund is miscategorised as a DIY option and DFA get the loophole closed when they find out about it – lest their advisor model is threatened.
@ Delta Hedge – I like the way you couch your view of the market price. Another question I’d ask is what is the market paying for and does it align with your needs an investor? For example, no point paying for linkers if you’re a young investor who can use equities to beat inflation over the long term.
Was it that Swiss negative yield that led to their central bank threatening to buy unlimited francs until the market stopped bidding up their currency?
@TA: I think it was our old friend Gary Stevenson who covered it recently.
This is what he says in his ‘This is how you make money trading’ nymag.com piece this year:
“Over the course of a single week in 2010, I lost $8 million betting on Swiss interest rates. One of the only things I can recall about the next several months of my life is a brief conversation. Actually, it was more of a monologue. I remember it because it is probably the most important exchange I have ever had in my life. I had become obsessed with understanding why I had lost that much money on a trade, and whether and how I would make it all back, and one part of that obsession involved going back to my textbooks from the London School of Economics. I stuffed them into my work bag and brought them to the 42nd floor of the Citigroup tower, and I read them in the afternoons when trading slowed down. I was looking for answers. Why was the Swiss franc appreciating? Was a negative 4.5 percent rate sustainable? Were the FX swaps prices really arbable?”
I suspect that Mr Stevenson’s loss here and the minus 4.5% p.a. yield arose from the Swiss National Bank intervention.
When that intervention abruptly ended the effects were both stark and swift. In 2015 when the SNB stopped trying to cap the Swiss Franc exchange rate to the Euro the Franc jumped 19% (a 180 sigma move) instantaneously relative to the Euro. In comparison the British Pound only dropped 8.1% (15 sigma) in the confusion after the Brexit vote.
The existence in the past of such big FX moves is perhaps one reason not to buy a currency unhedged version of a global index linked bonds ETF or a TIPS ETF.
Thanks for this detailed article @TA – quite the hand grenade! 😉
I’ve still got 3 or so years of accumulation to go and was quite happy with my 40% defensive assets split into mainly bonds/linkers and then cash/gold/commodities (12.5/12.5/10/2.5/2.5) with monthly rebalancing as I put new money into my SIPP. However, this article is enough to cause me to question whether the linkers are fit for purpose.
I’m struggling with how to consider a linker ladder as only part of this defensive allocation, but think the answer must be the rolling ladder you describe in December’s ‘Should you build an index-linked gilt ladder?’ post. Say I decided to take my current linker fund and convert it to a 3 or 5-year ladder – do you simply split equally across each year? What would I do in a few months when I had more funds to allocate to this ladder? Buy equal amounts of each year again? (I guess the fees might cause you to do it every 3m or 6m perhaps?).
I recall your clear explanation in the ‘No Cat Food Portfolio’ post about why you weren’t going to commit significant funds to a linker ladder. For simplicity, I may decide to simply increase my commodities (& maybe gold) exposure at the expense of some of the linkers going forwards…
@The Accumulator – no great insight I’m afraid, just eyeballing charts over the same period. I have chosen to focus on the Winton trend fund which has performed pretty well in recent years and seems to have a relatively low cost for this sector.
Downsides – I would say these funds are a bit of a black box so you are hoping the managers do a good job and are sensible, but the big plus (as I see it) is that they cover so many markets that they give great diversity to a portfolio with little correlation to equities and can perform strongly in challenging periods – I believe they also did well through the financial crisis for example.
There was of course the excellent Monevator ‘trend funds’ article earlier this year covering them.
@Sparschwein @TA. Thanks. I do hold some commodities and gold, in fact the latter turned out to be the best performer in my SIPP. Rather odd as it was anticipated to be a bit of a drag until the apocalypse. Perhaps the apocalypse has happened and I didn’t notice.
I have perhaps 20% across the board in short duration IL stuff as I pursue a pseudo natural yield approach to decumulation. Unlike most here ( age dependent thing) I can stomach portfolio value going down, or not matching a benchmark, providing I don’t lose catastrophically. The risk to be avoided is significant loss of capital ( say 30%) which I can’t recover in a relatively short period (3 years ?) or by being a forced seller. Perhaps the answer is to hold even more cash, say 5 years worth, and to hell with trying to be a clever dick trying to out think an uncertain future.
Rather late to this thread
There was as you would expect a long series of posts re TIPs linkers and retirement on the Bogleheads forum recently
The consensus seemed to be that a TIPs bond ladder worked but it required quite a high level of financial sophistication from the investor and probably was not a good idea for the more amateur of us
Certainly beyond my pay grade
xxd09
@ DaleK – yes, I’d buy equal amounts of each rung in the ladder.
How often you do it will depend on your broker’s dealing fee and the amount you have to invest. So for me, frequency depends on what proportion of the transaction I’m prepared to share with my broker.
Yes, 2.5% allocation isn’t likely to move the needle much but it is a toe in the water – good for acclimatisation.
Re: xxd09’s point about financial sophistication. Setting up a liability matching index-linked gilt ladder is quite a bit of work:
https://monevator.com/index-linked-gilt-ladder/
But, I don’t think it’s beyond the ability of most Monevator readers. Much of the problem, I think, is investing in individual linkers is a bit like using MS-DOS back in the day. It’s not very consumer-friendly, there’s lots of unfamiliar language to learn, and some idiosyncrasies to absorb.
A rolling linker ladder can be approached more heuristically – like a cash savings ladder. If you hold 5 years of cash laddered in fixed savings account then it’s quite straight-forward:
– You’re likely to save equal amounts in each unless you foresee an exceptional expense one year.
– When they mature you’ll either spend the cash or reinvest.
– Every year you’ll sell another asset (or redirect another source of funds) into a new rung in the ladder.
A rolling linker ladder is the same except while you’re holding to maturity you have to be strong and ignore price fluctuations along the way (unless you hope to make a quick buck with falling interest rates).
@ ChuckieB – that’s interesting. Thank you for the thoughtful reply. I’ll revisit that trends article.
@ Paul – on that basis short-duration linker funds seem like a good fit for you. I’ve been having a similar discussion with TI behind the scenes. He’s not that bothered about hedging inflation, hence there’s no issue for him either.
It probably is worth reiterating that a portfolio of individual linkers isn’t a source of greater return versus a similar portfolio structured as a fund. The advantage of the individual linkers is that they will track / hedge inflation if held to maturity.
Creating a TIPS ladder is a little bit more fiddly than a Gilts ladder but is doable (on Charles Schwab). The UK tax treatment of TIPS is very much less favourable than that of Gilts (broadly any profit in respect of TIPS is subject to income tax, whereas on low coupon Gilts the vast bulk of the economic return is a tax free capital gain).
@TA cheers. I meant to say that I also hold a 2032 IL gilt. This is via Halifax online share dealing account. Owing to cgt decided to hold this outside an ISA to make ‘better’ use of the ISA tax free benefit. It was not a big effort to buy but had to be by telephone and only clean price shown online. In terms of mechanics I don’t think it would be much of a big deal to set up a bond ladder. You would have to post the cash onto the platform first and decide the staggered holdings. ThinkI would talk to the platform first to ensure selected gilts were offered. Automatic dividend reinvestment might be problematic so perhaps expect coupons to just pay out.
But yes, having the account show an immediate 30% loss, in my case, because the software only sees clean price is disconcerting.
Apologies if you have already seen this. Supports commodities.
https://corporate.vanguard.com/content/corporatesite/us/en/corp/articles/hedging-portfolio-against-inflation.html
Making another attempt to wrap my head around linkers and if/how they can be used for inflation protection.
I used to think that the problem lies with the long duration of most UK linkers and/or the mechanics of funds (vs individual linkers).
But medium-duration individual linkers have done very poorly too recently, during a bout of inflation that should be the perfect situation for them to shine.
ILGs are linked to RPI. RPI is up 28% from Jan 2021 to Jan 2024.
The 0.125% 22/03/2026 Index-Linked Gilt GB00BYY5F144, bought in Jan ’21 with ~5 years maturity, *lost* 15% in value until Jan’24 (prices from HL, neglecting the small coupon payments).
This makes no sense – what am I missing?
@Sparschwein — Well you need to know what those intermediate linkers were yielding prior to the bond rout. I expect they too were priced to deliver a negative real yield to maturity (ceteris paribus) though not to the same extent as long duration linkers. (Unfortunately I don’t have the information to hand and am not sure how to obtain it now, but there was widespread reporting at the time that the asset class was at the peak/worst offering a negative real yield of 2-3%).
Then you need to see what yields linkers are currently on.
According to Tradeweb a ten-year linker is currently offering a yield of 0.6%.
Very different situation.
@TI – thanks good point. I seem to remember negative real bond yields of 3.something% (I’m not sure either where to find such data).
So if real yields increased by 4%, this would explain about half the missing return from this linker (5 years x 4% vs 28% RPI +15% drop in price)?
Investing is such a minefield. Buy an asset that has inflation protection literally in the name, and watch it crater when inflation comes. I’m glad I had largely abandoned bonds before 2021. But, as you say, the situation is different now.