The failure of index-linked bond funds to perform post-Covid has really been bothering me. What’s the point of these things if they don’t actually protect you from inflation? Meanwhile, individual index-linked gilts – correctly used – are meant to be a proper inflation hedge [1]. But is that true?
Can we empirically prove individual linkers1 [2] worked when inflation let rip?
First, some context. Our favoured linker fund holding at House Monevator prior to the post-pandemic price surge was a short-duration model. That’s because short-duration index-linked fund returns are more likely to reflect their bonds’ inflation ratchets, and are less prone to price convulsions triggered by rocketing interest rates.
Longer duration linker funds, meanwhile, got hammered in 2022 because they’re more vulnerable to rising interest rates [3]. When rates soared, prices dropped [4] so hard and fast that their bond’s inflation-adjustment element was rendered as effective as wellies in a tsunami.
Hopefully you at least avoided that fate…
The weakest link(ers)
So it’s October 2021, and you’re duly positioned on the coastline, scanning the horizon for inflation, with ample resources invested in short-duration linker bond fund units.
Here’s how our defences performed once the inflation Kaiju [5] was unleashed:
Inflation versus short-duration linker fund
[6]
Index-linked bond fund is the GISG ETF [7]. Data from JustETF [8] and ONS [9]. February 2025. NB. The linker fund trend line was corrected on 18 Feb 2025.
Oh. As that calm-voiced announcer-of-doom on Grandstand might have intoned: “Inflation One, Passive Investing Defence Force, Nil.”
Or, in numbers more appropriate to an investing article, the annualised returns from October 2021 (when inflation lifted off) to year-end 2024 are:
- UK CPI inflation: 5.9%
- Short-duration linker fund: 0.6%
Note: all returns in this article are nominal, dividends reinvested.
In other words, this linker fund fell far behind rising inflation and posted real-terms losses over the period.
Right-ho. So that was a learning curve.
Since then I’ve put a lot of time into researching individual index-linked gilts [10], commodities [11], gold [12] and money market funds [13] – all assets fancied as offering some degree of inflation protection.
The most reliable should be individual index-linked gilts. After all, they come with UK inflation-suppression built-in. Put your cash in, and it pops out at maturity, with a price-adjusted enamel on top. Purchasing power protected!
All you must do is not sell your linkers before maturity. Buying-and-holding prevents the kind of losses bond funds are vulnerable to realising. Funds’ constant duration [14] mandates make them forced sellers when bond prices are down.
Excelente! But one thing was still nagging me. Did individual linkers actually deliver on their inflation-hedging promise during the recent price spiral?
Inflation versus individual index-linked gilts
To answer that question, I simulated the performance of a small portfolio of individual index-linked gilts using price and dividend data from October 2021 to year-end 2024.
Then I pitted the individual linkers against CPI inflation and GISG, the short-duration linker ETF discussed above.
Here’s the chart:
[15]
Data from JustETF [8], Tradeweb [16] and ONS [9]. February 2025. NB. The linker fund trend line was corrected on 18 Feb 2025.
Okay, the individual linkers (pink line) did better than the fund but they still lagged inflation. The annualised return numbers are:
- Inflation: 5.9%
- Individual linkers: 4.1%
- Linker fund: 0.6%
That’s still an unhealthy gap as far as I’m concerned – like buying a peep-hole bulletproof vest.
Proving a negative
Why did the individual index-linked gilts lose money versus inflation?
Because way back in 2021 they were saddled with negative yields. That is, the buy-in price for linkers was so high that their remaining cashflows were guaranteed to sock you with a loss, if you held them until maturity.
The best a linker portfolio held to maturity could do was limit the damage against inflation. But that negative yield drag meant it was always going to underperform.
But that’s a historical problem. Today index-linked gilts are priced on positive yields, so they can keep pace with inflation while sweetening the deal with real-return chocolate sprinkles on top.
The other point worth making is that my clutch of individual linkers were still susceptible to the downward price lurches that afflicted constant-duration bond funds.
The chart above shows a big dip in late 2022 when prices fell as interest rates took a hike, for instance. Think Trussonomics [17] and other traumas of the era.
These are only paper losses to the individual linker investor who holds until maturity or death. Hold fast and eventually your bond’s price will return to meet its face value on redemption day (plus inflation-matching bonus in the case of linkers.)
Meanwhile, the bond fund is flogging off its securities all the time – profiting when prices rise and losing when they fall. That was a very bad design feature during the post-pandemic inflation shock.
My individual linkers’ price dip was smaller than the fund’s largely because I could choose to populate my modelled portfolio with shorter-duration bonds. Short bonds are less affected by interest rate gyrations, as discussed.
Still, I wondered if I was being unfair to the fund. After all, linker funds previously gained in 2020 as money flooded into the asset class.
One last chance for the linker fund
The next chart shows annual returns including 2020, the year before inflation ran hot.
[18]
Index-linked bond fund is Royal London Short Duration Global Index Linked M – GBP hedged.2 [19] Data from Royal London [20], Tradeweb [16] and ONS [9]. February 2025.
Yep, 2020 was a good year for the linker fund. Interest rates fell and its price rose giving it a healthy lead over inflation, and the individual linkers. (Remember the fund profits by selling bonds as prices rise. Meanwhile, the longer average duration of the fund’s holdings meant that it enjoyed a stronger bounce versus my battery of gilts.)
There’s not much to see in 2021 – bar inflation engorging itself – but 2022 is the fund’s annus horribilis. It’s down 5.4% at face value and 16% in real terms. (Horrifyingly, the long-duration UK linker ETF, INXG, was down 45% in real terms that same year.)
Overall, incorporating 2020 does improve the linker fund’s showing. The annualised returns for the five year period 2020 – 2024 are:
- Inflation: 4.6%
- Individual linkers: 3.7%
- Linker fund: 2.2%
It’s still not enough. In my view, the best linker funds available were a fail when inflation actually came calling. I personally held both GISG and the Royal London fund at the time and became deeply disillusioned with them.
All change
The issue driving all this drama was that as inflation accelerated, investors demanded a higher real yield for holding bonds.
The average yield of the simulated linker portfolio above was -4.2% in October 2021. It had risen to 0.5% by December 2024.
When bond yields go up, prices go down. And that exposes the fatal flaw in linker fund design from an inflation-hedger’s perspective – the available products are always selling and even the short duration versions aren’t short enough.
Perhaps yields won’t surge as violently in a future inflationary episode.
But I don’t see why I’d take the risk when I can now buy individual index-linked gilts on positive real yields, hold them to maturity, and neutralise that problem. Individual linkers aren’t going to be slow-punctured by negative yields from here.
So I’ve ditched my index-linked bond funds. They were better against inflation than the equivalent nominal bond funds. But that’s not saying much.
There are other places to store your money so I’ll extend this comparison to the most interesting and accessible of those alternative assets in the next post.
Take it steady,
The Accumulator
Bonus appendix
If you’re interested in buying individual index-linked gilts then these pieces will help:
- Should you build an index-linked gilt ladder [21]
- How to buy index-linked gilts [22]
- Index-linked gilts: how to price, value, and track them in your portfolio [23]
- How to build an index-linked gilt ladder [24]
Are individual linkers better than linker funds?
At hedging inflation yes. At being more profitable, no.
For the avoidance of doubt, I’m not saying that a portfolio of individual index-linked bonds can magick up more return than a bond fund containing precisely the same securities.
What I am saying is that the individual linker portfolio is the superior inflation hedge when each bond is held to maturity. The design of constant maturity bond funds mitigates against matching inflation in the short-term, but should provide a similar overall return in the long run.
If you don’t care about hedging inflation then there’s nothing to gain by swapping your bond funds for a rolling linker ladder.
Fixed duration index-linked gilt funds could also hedge inflation effectively, but they don’t exist.
UK inflation versus globalised inflation
It’s worth mentioning that individual index-linked gilts are linked to UK RPI inflation (switching to CPIH in 2030). RPI was higher than CPI during the period so that’s helped my simulated portfolio claw back some ground against CPI.
By contrast, the short-duration linker ETF, GISG, currently allocates 14% of its portfolio to index-linked gilts. The rest is composed of other developed market, CPI-linked, government bonds: 56% US, 10% France, 7% Italy and so on. The point being that these other linkers don’t protect against UK inflation, though they do match related measures i.e. inflation in highly interconnected, peer economies.
As it was, inflation in these other countries was typically less than the UK’s post-pandemic. I haven’t attempted to calculate what difference this made but I think it’s another reason to favour an index-linked gilt investment product when you can get it.
Individual linker portfolio simulation
I didn’t want to bog the main piece down with a wander through the weeds (well, more than I already have) but for the record I’ll now show my workings.
The individual linker portfolio was constructed from three index-linked gilts, TIDM codes: T22, TR24, and TR26. Each gilt matures in the year indicated by the numbers in the code.
When each gilt matures, the redemption payment is reinvested into the next shortest gilt. For example, T22 is reinvested into TR24. I did not include trading costs for reinvesting dividends or redemption monies.
Relatedly, the performance figures for GISG and the Royal London fund are slightly affected by their OCFs of 0.2% and 0.27% respectively. But I don’t think these charges made a meaningful difference to the comparison over such a short time-period. The differential is too big to be explained by fund fees.