Surging inflation is one of the nastiest, portfolio-crumbling threats investors face – not least because defending against it is as difficult as defeating dry rot. The last few years have taught us a great deal about what does and does not work, so here’s our updated guide on the best inflation hedges.
Note: All investment returns quoted in this article are annualised real returns.1
How to hedge against inflation
There are three asset classes worth considering as inflation hedges:
A good inflation hedge should:
- Respond quickly to high inflation, with correspondingly high nominal returns.
- Work reliably across many different time periods, countries, and inflation regimes.
- Deliver reasonable long-term returns over time.
Not a single asset class (including our three prospects above) comfortably fulfils our definition of a ‘good inflation hedge’. I’ll explain why below.
And so sadly there is no magic bullet answer to the question: “what is the best hedge against inflation?”
Taken together, the top inflation hedges resemble a ragtag crew of mercenary misfits. Sometimes they’ll come through for you: unleashing a spectacular display of inflation-busting pyrotechnics. Other times, they’ll fall on their face like a drunk, trousers round their ankles. An embarrassing mistake.
These complications mean we believe deliberate inflation-hedging is a less attractive option for early- to mid-stage accumulators than for near-retirees and decumulators.
When you’ve decades to go, concentrate on beating inflation over time with a strong dose of global equities. That makes more sense than hedging against a short-term risk.
As for near-retirees and decumulators, let’s consider which of the reputed inflation hedges you may want on your side.
Inflation hedge: index-linked gilts
If you buy individual index-linked gilts (not index-linked gilt funds or ETFs) then they will hedge against UK inflation provided you hold them until maturity.
For example, if you put £1,000 into the index-linked gilt UKGI 1.25 11/27 – and hold until maturity – then your £1,000 will grow in line with RPI, until your capital (or principal) is returned to you on the bond’s 22 November 2027 maturity date.
On top of that, if you reinvest your RPI-adjusted coupon (interest) payments into the bond, then you’ll approximately earn the current real yield of 0.11% per annum.
That is far from an awesome return. But it’s better than the negative rates inflation-linked bonds were earning until recently.
And at least you know that money invested on this basis will keep pace with inflation.
For Brits, this is the best inflation hedge you can buy in the sense that it will reliably protect your purchasing power against official inflation.
That’s because no other investment is index-linked to a UK inflation measure.
Caveats a go-go
If you sell your individual index-linked gilt2 before maturity then you may make a capital loss (or gain) due to price risk.
Price risk is the risk that the price of your bond drops as its real yield changes before maturity.
If bond yields spike hard and fast enough, then a linker’s price can fall so far that you’re not adequately compensated by the bond’s inflation-linking features.
But – and forgive me for going on about it – bond mechanics mean you can defuse any price risk simply by holding your bond to maturity. (You must also reinvest your coupons in a timely manner to earn the real yield on offer when you bought in, too.)
Price risk is the reason why inflation-linked funds and ETFs are not a guaranteed inflation hedge.
Bond managers typically sell their securities before maturity in order to maintain their fund’s target duration.
As interest rates took off in 2022, managers were therefore booking capital losses as prices fell in response to rising bond yields.
The longer your fund’s duration, the deeper your loss. Short-duration inflation-linked funds were less badly damaged, but they still didn’t keep up with inflation in 2022 and 2023.
For more on how to buy and use individual index-linked gilts, read up on how a rolling linker ladder works and learn how to build an index-linked gilt ladder.
If you maintain part of your portfolio as a ladder of individual index-linked gilts then you can sensibly leave your inflation-hedging efforts at that.
But…
Vanguard points out that index-linked bonds aren’t likely to prop up the rest of your portfolio when the money-munching monster runs amok.
That’s because short-term index-linked bond yields are so slim, that our allocation can’t be expected to do much more than return your money with a few inflation-adjusted sprinkles on top.
(Note, Vanguard talks about US TIPS. But the same is true – perhaps more so – for inflation-linked gilts.)
More concretely, linkers fall short of our ‘deliver reasonable long-term returns’ criteria.
So let’s push on and look at the inflation-hedging properties of commodities.
Inflation hedge: commodities
Numerous research papers point out that commodities sometimes deliver exceptional returns in the teeth of inflationary pressure.
It certainly makes sense that commodities should serve as some kind of inflation hedge, given that the cost of raw materials is often one of the booster rockets strapped to accelerating prices.
That said, most of the research examining the issue is problematic. Usually because the data doesn’t reflect investable commodity indexes, or is quite short-term, or is US-oriented, and so on.
Nonetheless, your heroic Monevator correspondent partially mitigated his own cost-of-living issues by spending time digging up relevant broad commodities data and plotting it against UK inflation – instead of blowing his cash on having a life. You’re welcome.
My conclusion?
Commodities are a partial inflation hedge.
The asset class has delivered spectacular returns at times as inflation begins to stir.
Often the lift-off in commodities presages escalating UK inflation further down the road.
But by the time headline rates are hurting our pockets, commodity prices are often tumbling back down again.
Over a one-year period, commodities are actually negatively correlated with UK inflation (1934 to 2022).
However, commodities outdid the other major asset classes when inflation was above-average (1934 to 2022).
Average annualised returns during inflationary episodes were:
- Commodities: 4.5%
- UK equities: 3.6%
- Gold: 1.8%
- Gilts: -2.2%
- Cash: -1.9%
Meanwhile, the historic annualised real return of commodities was 4.5% (in GBP) across the entire time period from 1934 to 2022.
Thus an allocation to raw materials historically fulfilled the ‘deliver reasonable long-term returns’ part of the brief.
And they have generated extremely high, inflation-beating nominal returns at times.
But commodities cannot be said to work reliably as an inflation hedge. You can shape them around your portfolio like an armoured plate, but you can’t expect them to deflect every inflationary bullet.
Finally, the USP of commodities is also its biggest weakness.
Commodities are useful primarily because they’ve been historically negatively correlated with equities and bonds. And equities and bonds tend to fail together during bouts of galloping inflation.
But commodities can be a terrible drag when the commodity asset class suffers a bear market. The beating taken by commodities between 2008 to 2020 would have shaken the resolve of even the most fanatical inflation-phobe.
We recommend reading the recent Monevator commodities series and researching the asset class yourself before committing any cash.
Inflation hedge: gold
The case for gold as an inflation hedge is similar to – but weaker than for – commodities.
At best, gold’s performance can only be appropriately measured from 1968. That’s because it was caged by government regulation before then.
Monevator investigated the behaviour of gold versus UK inflation when we asked: is gold a good investment?
The long and the short of it is that gold is historically uncorrelated to inflation. You can’t rely on the yellow metal as an inflation hedge.
So why are we even talking about gold? Because it is also negatively correlated with equities and gilts. So occasionally the shiny stuff’s good years have coincided with bouts of unexpected inflation.
Gold just bobbed ahead of inflation in 2022 and 2023. It also had a reasonable 1970s during that stagflationary era.
Golden years
The US-orientated, 2021 research paper The Best Strategies For Inflationary Times stated that gold turned in average returns of 13% during four inflationary regimes post-1971.
But the paper’s authors then break our hopeful hearts by warning:
Looking at averages over all regimes could be misleading because of one influential regime. For example, Erb and Harvey (2013) show that gold’s seeming ability to hedge unexpected inflation is driven by a single observation.
And here is that single observation. The gold price shot up near 200% in 1980:
Source: Claude Erb and Campbell Harvey. The Golden Dilemma. 2013. Page 9.
Even Erb and Harvey say of gold’s relationship with unexpected inflation:
There is effectively no correlation here. Any observed positive relationship is driven by a single year, 1980.
Meanwhile, the long-term GBP annualised returns of gold are hard to pin down. Take your pick from:
- 1900-2022: 0.8%
- 1968-2022: 3.5%
- 1975-2022: 1.5%
Ultimately, gold is a total wildcard.
It may work during an inflationary crisis: the charts show it soaring like a NYC pencil-tower during some years in the 1970s.
You’d always want gold in your portfolio if you could rely on it doing that.
But then again, gold suffered a 19-year horror show from 1980 to 1999. Losses peaked at -78%.
Accumulators can happily skip the quandary. Decumulators who want to ward off sequence of returns risk may want to use gold sparingly as disaster insurance.
But the case for gold as an inflation hedge is weak.
Inflation hedge: real estate
Property is often named on the roster of potential inflation hedges. However, the renowned investment researchers Dimson, Marsh, and Staunton found that commercial real estate returns are negatively impacted by high inflation, though less so than broad equities.
However, that could be an artefact of sluggish property prices. In other words, the inflation effect is simply delayed in comparison to liquid equity markets.
Because REITs have reasonable long-term returns but a negative relationship with inflation, we think commercial property is best thought of as an inflation-beating strategy. As opposed to an inflation hedge.
Dimson, Marsh, and Staunton tentatively suggest that residential property is quite resistant to inflation. But returns still have a negative relationship with high prices.
However the verdict in The Best Strategies For Inflationary Times is a little more encouraging.
UK residential property delivered a 1% average return during high inflation periods. Returns were positive in 57% of the 14 periods examined between 1926 and 2020.
Incredibly, Japanese residential property delivered 12% average returns with a 100% positive return across six high inflation episodes from 1926 to 2020.
But US residential property returns were -2% during inflationary bouts. It only mounted a positive response a quarter of the time.
Location, location, location
Keep in mind that unique factors could be at play in each of these markets.
And we also can’t ignore the fact that historical records of property prices are notoriously problematic.
Long-term data typically fails to capture high-resolution details such as ownership costs, rental assumptions, taxes, default risks, transaction costs, and illiquidity.
You have to put a peg on your nose every time you lend credence to historical property returns.
UK homeowners conditioned by a 30-year property bull market have long thought of their castles as a bastion against inflation.
And residential property did deliver a positive return in two out of three episodes during the ‘70s, according to The Best Strategies For Inflationary Times.
But that’s little comfort for anyone struggling to get on the housing ladder.
Moreover, it’s difficult to diversify residential risks.
Even a portfolio of rental properties is prey to local market conditions. These can swamp any inflation effect.
Inflation hedge: stocks and equity sectors
Can individual stocks or sectors serve up inflation hedging salvation where the broad equity market cannot?
Dimson, Marsh, and Staunton sound dubious:
It is tough to find individual equities, or classes of equities, or sectors that are reliable as hedges against inflation, whether the focus is on utilities, infrastructure, REITs, stocks with low inflation betas, or other attributes.
Meanwhile, Neville et al investigate the performance of 12 US stock sectors in The Best Strategies For Inflationary Times. Every sector except energy stocks posted negative returns during high inflation periods.
The energy sector did manage a 1% average return during those periods. But the return was only positive 50% of the time.
Notably, average returns were -19% during the 1972-74 recession that was infamously fuelled by the OPEC oil embargo.
Ultimately, equity prices are subject to a swirl of forces beyond inflation. These can confound a simple thesis such as ‘high oil prices must be good for oil firms’.
Looking for the X factor
Three other equity sub-asset classes posted positive returns during high inflation regimes according to Neville et al. These were three of the risk factors:
Momentum looks especially hopeful, with 8% average returns and positive returns in three-quarters of the scenarios considered in The Best Strategies For Inflationary Times.
The snag is these compelling results tested the ‘long-short’ version of cross-sectional momentum.
But us ordinary UK investors can only access long-only momentum ETFs. Which offer a diluted version of the pure form examined in the paper.
Once again our hopes are stymied by the gap between backtested theory and investible reality.
The authors also say they’re cautious about momentum’s results, due to its low statistical significance and its sensitivity to their chosen dates:
For example, January 1975 was a very negative month for cross-sectional momentum, and our inflationary regime stops in December 1974. Equally, late 2008 through early 2009 was catastrophic for momentum, and our inflationary period ends in July 2008.
However, the authors do make encouraging observations about the benefit of straightforward international equity diversification:
Equities really only struggle when two or more countries are suffering. This is consistent with a global bout of inflation being very negative for equity markets.
The results also suggest benefits to international diversification. For example, taking the UK perspective, US and Japanese equities generate +6% and +9% real annualized returns during UK inflation regimes, respectively.
This is perhaps one of the drivers behind the large international equity allocations run by some of the major UK pension funds coming out of the inflationary 1970s and 80s.
Inflation-hedge: timberland
Timberland enthusiasts describe it as the dream package. Who wouldn’t want an inflation hedge that offers good risk-adjusted returns, plus low correlations with equities and bonds?
But even fund managers selling timber investments confess the asset class has been a moderate inflation hedge at best.
Alternative investment firm Domain Capital states:
Timber has been found to be positively correlated with unanticipated inflation. During periods of high inflation, as in the 1970s, timber provided a partial inflation hedge. With a correlation of 0.34 to inflation during the 1970s, timber prices tended to outpace unexpectedly high inflation.
Here’s a recap of how correlation metrics work:
- 1 = Perfect positive correlation: when one thing goes up so does the other
- 0 = Zero correlation: the two things being measured have no influence upon each other
- -1 = Perfect negative correlation: when one thing goes up, the other goes down
A correlation of 0.34 during the stagflationary 1970s is not great.
The timberland / inflation correlation then drops to 0.29 between 2003 to 2017.
Between 1987 and 2010, the correlation was 0.64 according to Barclays Global Inflation-Linked Products – A User’s Guide.
That compares with inflation correlations of 0.80 to commodities and 0.84 to short-term index-linked gilts.
But the even bigger problem I encountered when trying to stand up timberland is that sources tend to use data from the NCREIF Timberland Index.
This US index has two main issues:
- It only tracks timberland’s performance from 1987. That’s a pretty short timescale. Especially given that – until recent years – inflation had been quite benign since the late 1980s.
- The index is dominated by private equity companies that invest in timber and forestry. Those companies are inaccessible to retail investors like us.
Instead, we can invest in publicly-traded timber REITs and forest product companies.
Barking up the wrong tree
The S&P Global Timber & Forestry Index is the most popular index covering public timberland firms.
You can gain exposure to it via an iShares ETF with the ticker WOOD. (See what they did there?)
But we’re stumped again! Public timber stocks are much less effective inflation hedges than their private equity brethren, according to the paper Assessing the Inflation Hedging Ability of Timberland Assets in the United States.
Its authors concluded:
Private-equity timberland assets can hedge both expected and unexpected inflation, and the ability becomes stronger as the investment time increases.
In contrast, public-equity timberland asset is not effective in hedging either.
As for timberland’s diversification benefits, they say:
In summary, private-equity timberland assets have a negative correlation with the market and are a good hedge against actual inflation.
On the other hand, public-equity timberland assets behave more like common stocks and have a high correlation with the market.
The study covers the period 1987 through 2009. But it chimes with my anecdotal experience of keeping an eye on iShares’ WOOD.
WOOD’s returns have been closely correlated to MSCI World ETFs. Ultimately, I’ve not been able to justify branching out into timber. [Ed – fired!]
Inflation hedge: trend following
Trend-following scored average returns of 25% in inflationary periods according to The Best Strategies For Inflationary Times. It also worked reliably in all eight scenarios.
Returns for the entire 1926 to 2020 period were an astounding 16%.
At this point, I wish I knew how to execute a proprietary trend-following strategy using futures and forwards contracts associated with commodities, currency, bond, and equity prices.
Because that’s what the authors backtested.
They name check their methodology. But I’d guess this strategy is beyond the ken of most people.
Other inflation hedges
Our final inflation hedging candidates are collectibles: wine, art and stamps.
The Best Strategies For Inflationary Times suggests they have game:
| Collectible | Inflation episode average return (%) | Anti-inflation reliability (%) |
| Wine | 5 | 50 |
| Art | 7 | 63 |
| Stamps | 9 | 75 |
But once again the academics are building a case on an index you can’t invest in. The underlying data ignores transaction fees, storage, and insurance costs. All of which would chomp down those returns.
Moreover the average punter is going to struggle to put together a diverse basket of Old Masters.
Right now there’s no ETF tracking the market for Picassos, Warhols, and Cézannes.
If you can profitably swim in those waters then the best of luck to you. But hopefully you’re not just sticking this treasure in a vault for the purpose of inflation hedging.
The Investor covered some of the pitfalls of investing in illiquid and opaque markets in his piece on alternative asset classes.
Beating inflation
So where does that leave us, except more disillusioned than ever?
As previously stated, because inflation hedging is so problematic I’d skip it if I was still an accumulator saving for retirement. I’d rely on straightforward global equities to beat inflation instead.
But decumulators and retirees are highly vulnerable to unexpected inflation.
The most reliable buy-and-hold method to hedge inflation is to create a ladder of individual index-linked gilts.
You might also consider an allocation to broad commodities and even gold as modelled in our decumulation strategy portfolio.
Hedging your hedging bets
You may consider inflation to be such a threat that it justifies a small percentage to each of the assets we’ve covered. This way you have a diversified hedge against inflation.
Is it worth it? Only you can decide what’s right for you.
I’ll give the last word to Dimson, Staunton, and Marsh. Their peerless work acts as a shining light for us ordinary investors in search of answers:
Inflation protection has a cost in terms of lower expected returns. While an inflation-protected portfolio may perform better when there is a shock to the general price level, during periods of disinflation or deflation such a portfolio can be expected to under-perform.
Take it steady,
The Accumulator
Gold and 40 year period 1980-2001 ?!
@TA – well, that was depressing! But thanks anyway 🙂
I guess the only thing to do is hunker down. I’ve got a hedged intermediate index linked bond fund (GISG, duration about 5 years) and gold (too much for comfort, plan to glide path into Equities) and that’ll have to do. My best inflation hedge is the state pension and my small civil service pension. but I’m 11 years away from them.
I’m about to pull the trigger but maybe another year wouldn’t hurt… It’ll boost my civil service pension and reduce what I’ll need to draw down, though I’ve got plenty of non-equity to bridge the gap. I suppose in a year, we’ll also see just how “transitory” this inflation is.
Btw, wine is an excellent inflation hedge! It’s also an effective hedge against deflation, unemployment, employment, small children, annoying bosses, objective setting, performance mismanagement, and all other corporate bs. These guys clearly don’t know what they’re talking about!
@Brod, while my stash of vino plonko won’t hedge against inflation, it at least makes the end of a day feel better. I fear I enjoy wine too much to be able to maintain large stocks of Cru classé en primeur – which are the ones the articles talk about.
@ Jim – thank you! I seem to have found a couple of extra decades there. Weird because normally I lose them. Also, The Monevator subbing department wants sacking #4,096
@ Brod – agreed. The academics have dramatically underestimated the upside of wine. Especially as a hedge against depressing news like there aren’t many good inflation hedges.
@TA – yes, well if we weren’t all dead in the long run, maybe we’d come out ahead…
@Jonathan – I’m well aware of the types of “investable” wine. And, of course, not any old cru classé. It’d have to be one of the Premier or maybe a super-second. Not the waters I dip into.
You are too hard on linkers. If I buy at current real yields, c.-2% pa say on 10y, then yes that’s expensive (tho they were recently on -3%) but the maturity payout is guaranteed to match inflation (at least as measured by RPI/CPI/whatever) minus that cost. So in a 10% inflation scenario at least I know I’ll get 8%. This is the rationale behind institutional pension fund LDI strategies, widely denigrated by many traditional active managers who don’t really understand the importance of a guarantee. And while 2% may seem outrageous it’s probably what a lot of punters are paying Rathbones, SJP etc for the privelege of expert active management with no guarantees whatsoever.
My inflation hedges are having a really big mortgage and not overpaying it (debt will get inflated away as long as salary keeps up with inflation), real estate both physical and REITs like RECI or SUPR (c85% rents linked to inflation, although many are capped at max 4%), Energy eg, TRIG (benefits from higher energy costs and also many contracts still inflation linked and gov backed) and have just bought a little bit of a windfarm cooperative (Ripple Energy) which will take the edge off any electricity bill rises for the next 25 years 🙂
The best way I could figure to hedge against inflation and to manage cash flow in a down market was to buy a web business. So I went out and did that last October, and so far seems to be doing the trick. My cash flow is going up, and inflation risk is going down as I can keep more of my cash in the market. So fingers crossed that this strategy continues to pay off, because it sure has been WORK.
Nice post and as you say: this horse has long bolted!
In general: the best time to buy linkers, etc is when nobody else is buying them.
Way back in the mists of time (pre-Monevator) the UK government offered index linked savings certificates offering guaranteed inflation protection plus a premium to ordinary people via NS&I
The index linked savings certificates were offered pretty much annually in 3 and 5 year durations with a maximum individual subscription since 1975
By subscribing to successive issues you could build up up to six figures in these products
Naturally the tories felt these useful products were too good for plebs and discontinued them in 2011
@ Neverland – Yes, the dearly departed index-linked saving certificates would be an ideal way for regular punters to hedge against inflation. I read that they were put on ice because the government could get a lower interest rate from the bond market. In other words, ordinary saving folk could go do one.
@TA, @Neverland:
No new index-linked saving certificates (ILSC’s) were available after Sept 2011, see also:
https://en.wikipedia.org/wiki/Index-linked_Savings_Certificates
Existing certificates can be renewed albeit that from 2019 indexing is to CPI (rather than RPI) and the premium is now 0.01% – but they are tax free.
We covered NS&I index-linked certificates back when they were still a live thing:
https://monevator.com/tag/national-savings-certificates/
The following line jumps out from 2011 🙂
https://monevator.com/weekend-reading-grab-those-index-linked-certificates/
With that said, the return would have been absolutely trounced by a world tracker over the next ten years…
Baked beans.
@ Al Cam – I know! I’ve got one tranche from that final issue which I will never stop rolling over (hopefully). Point is, nobody has been able to save into new issues ever since. I don’t have enough but I know people older than me who’ve got a shed load.
@ Hague – very good point 😉 Though I shudder to think what post-apocalyptic wasteland I’d be trading my last tin of baked beans in.
@Hague – No, wine! 🙂
@ The Accumulator
I’m an “older person” (66) and have getting on for £120k (current value) of index linked savings certificates. I still wish I’d started buying earlier than I did and also bought more than the £15k (original value) I hold in my wife’s name. During times of low inflation with above inflation interest rates there were plenty of people suggesting they were probably not worth keeping (including, I think, Martin Lewis on MSE). I must admit I was tempted to cash in at times. When I look at the growth shown on recent annual statements I thank my lucky stars I held on to them. If it wasn’t for the fact that I remember the very high inflation rates in the 70s I probably would have cashed them in and now be kicking myself.
I managed to buy two £15k tranches of ILSCs before they were canned. I agree with Sean (17) that the sentiment around them at the time was that the returns they gave were not very attractive. Accordingly I only committed to a three-year term when I bought the first tranche in 2010. No real harm was done as I was able to roll them over to a five-year issue when they matured. I bought the five-year term at the outset for the last issue in 2011.
Yes, I have an originally £15K sum in ILSC too (now over 20K). I wish I’d been able to afford more way back when.
I installed solar panels as a hedge against inflation around 10 years ago (and recently put a chunk in Ripple Energy) – and this together successive energy saving measures means my energy bills have barely moved in the last five years.
I also tend to buy in bulk when it comes to long life food and other goods. I’m still using end of line/highly discounted washing powder from around five years ago. It has also proved useful with bicycle parts which have gone up astronomically over the last few years due to pandemic shortages and the public’s renewed interest during lockdown.
There’s one hedge that will always work: cut back on discretionary spending and get a higher paying job.
Re “personal inflation rate”:
The ONS recently revived their personal inflation calculator, see: https://www.ons.gov.uk/economy/inflationandpriceindices/articles/howisinflationaffectingyourhouseholdcosts/2022-03-23
@ Sean – I had a similar experience with relatives who couldn’t see the point of keeping index-linked certs when inflation was so low. They lived through the 70s too. It’s funny how memory fades.
@ Al Cam – Thank you for that link. Very timely!
Great article really made be think, paints a bleak picture if your retired and concerned about inflation.
As a decumulator I hold gold as it has increased the safe withdrawal rate and lowered the worst drawdown of a 60/40 portfolio quite a bit, see portfolio charts.
Linked is a problem for a UK investor, a short term active alternative that may be worth considered is MG inflation linked corporate bond which includes government short liked bonds. performed very well over the last 6 months compared with government nominal and linked index bond funds
@Al Cam (21) Thanks for the link to the ONS personal inflation calculator. It threw up an answer of 9.2% for me. The two biggest categories contributing to my personal inflation were car purchase and holidays. The calculation is a little arbitrary as I own a low-cost three-year old car that I bought new outright and will keep until I have run it into the ground. I entered the amount that I earmark from my cash savings each year to go towards its eventual replacement. As for holidays, I entered the amount that I could have imagined spending if we hadn’t been in a pandemic!
@DavidV (#24):
I have been doing a similar calculation for some years now – and our inflation rate has usually been a tad below that reported by the ONS. However, this year (so far at least) the divergence versus CPIH is noticeably larger than versus CPI.
A few weeks ago we talked about an LDI paper. I did eventually find a link. However, both times that I have tried to post this link for you via Monevator comments it has failed to show up. If you type: “Idzorek T & Blanchett D LDI” into google then the second hit should be a link to a Journal of Investing magazine. Page 31 onwards is IMO a minor tweak of the original 2017 LDI paper.
@Al Cam (25) Thanks for the search suggestion. I tried it and, from the first few results, without having a subscription I could only get as far as the abstract for the article . I had a further look down the search results and at about number eight I came across the full Feb 2019 issue of the journal, which was accessible. It is now clear that this is what you found, as at page 31 is the article in question. Needless to say, at over 20 pages, I haven’t read it yet. I’ll report back when I have done.
@ G – sorry, forgot to acknowledge the 5-year-old washing powder Tenth Dan mastery. This is the kind of Personal Finance speakeasy where that kind of effort deserves a hat tip 🙂
@Al Cam (25) I’ve now been able to have a quick read of the LDI for Individual Portfolios article. I thought this conversation may be in danger of being severely off-topic, but was heartened to see Exhibit 9 in the article where they use an optimisation analysis to determine the allocations for different liabilities and risk appetites. As one of the liabilities is inflation, this brings the conversation right back on topic! Even where the liability is represented directly by inflation, only the most conservative portfolio has any significant allocation to short-term TIPS and this is less than 20%. In each of the portfolios, nominal bonds and even long-term nominal bonds seem to have a much larger role than I would expect when the liability is represented by inflation. I remain dubious whether anyone would actually set their asset allocation in accordance with what this optimiser spits out.
@David,
The disclaimer towards the end of page 37 probably applies and “For all three splits for comparison, the asset-only allocations are significantly different from the liability relative optimizations. In general, the asset allocation differences are greater among the fixed-income asset classes.”
I bought some index linked gilts, and ordinary gilts (VGOV), hundreds of thousands of each about 6 months ago.
VGOV has dropped 12%. I’m beside myself with misery about why I ever did this.
The index-linked ones (the two suggested in Monevator) have dropped about 0.1%.
So whilst the index-linked ones haven’t been a great inflation hedge, there a damned sight better than p***ing money away on VGOV (mixed UK gilts of average duration 13.5 years) 🙁
@Valiant — Yes, it’s miserable isn’t it. Was bound to happen one day though, and after 10 years of it seeming to be in the next six months the day finally came.
I don’t know what your overall financial position is — and obviously it’s no consolation to you — but I’ve been buying government bonds with the intention of holding them for the first time in years in 2022. We’re talking about 12% of my total portfolio so far (and that includes corporate and active high yield funds, the latter of which @TA would say are from my equity allocation).
Of course I bought some INXG (UK index-linked) despite understanding the duration risk, and am down just over 10%. However this is still barely a 2% position, and I expect to add to it over time.
TLDR: at least bonds getting cheaper means bonds (and their benefits) are getting cheaper for new money…
That was a very good ,detailed run through of options i appreciated reading. through. thanks
lets hope high inflation dos’nt last too long.
Still got a large slug in cash ,thinking i would like to enter the gov nominal bond market tracker fund, once interest rates settle , and things normalise abit would that be a good time?.
@The Investor. Thanks for sharing my pain ;-). My Gilt and Index Gilt holdings each represent about 12% of my portfolio, which is: Equities: 59%, Gilts 22%, Gold, 12%, Cash 7% temporarily, with the intention to move the cash into equities over the course of the next year.
I had never previously owned Gilts and only bought them because 6 months ago I entered the decumulation phase. What a dreadful mistake. I blame Lars Kriojer :-).
I still think it is too soon to buy into intermediate to longer duration bonds, but by the end of the year they will be looking a lot less risky (especially vs equities) as the yields climb further to at least get closer to inflation than they are presently.
My rough targets to start buying at are US Treasuries and UK investment grade corp bond funds at 4%, EM $ bond funds at 7%+. At least they then start earning their keep within an income portfolio, and keep paying out while equities can have dividend cuts.
The Investor, TwentyFour Select Monthly Income Fund Limited (SMIF) is currently displaying a 7.36% dividend yield if you are into that sort of thing, it is sort of a mix of GBP junk debt. It does jump around a bit though.
I didn’t like US high yield bond ETFs after the Fed started buying them and drove the yields so low (sold out and took some profits). But once yields on them climb much over 6% they might be interesting again and less volatile than US equities. As you say this high yield stuff can behave closer to equities than treasuries, but I think it can have a place if you are after income and trying to keep up with inflation. Maybe only at 10 or 15% of a portfolio though.
@SemiPassive — Thanks, I’ve jumped in and out of that a bit. Currently out. I do have a couple of other high-yield ITs currently, which I’m carrying at a very small loss.
As I always stress my positioning is extremely fluid typically, so nobody should take my comments above as some sort of ‘call’ on whether it’s time to buy government bonds or not. 🙂 I could have no bonds in a fortnight, though I do think that’s unlikely. I am trying to force myself to de-risk a bit in my old(er) age, and hence I want to get and keep a foot in the government bond camp.
Since everyone hates them it feels like a good time to get started haha, but baby steps given the regime change seemingly going down.
Unless I have missed something above, there is one true inflation hedge available to UK investors of ‘mature years’ if they have a private pension, and that is a ‘real annuity’. This is a single premium pension lifetime annuity pegged to any increases in the RPI (some have a ‘no reduction’ floor, too, were the RPI to fall, when they become static). Around 95% of pension annuities bought in the UK are fixed in payment. That might be a sensible choice in the context of the individual’s other retirement income, but I do meet people who face a decline in living standards in old age as they put too much faith in low inflation and dying early! Most of us underestimate our life expectancy but living well beyond age 80 isn’t so unusual nowadays, so having at least some ‘real annuity’ income makes good sense.
@Mark Meldon: thanks for flagging this up. I looked into this a year or two back, as an option to put some of my deaccumulation money into. At that time the RPI on the leading products was capped; not sure if this is still the case?
Also, per Lars Kroijer, you are, unlike your public-sector counterparts, taking a counter-party risk on the viability of annuity issuer. Of course it’s quite small – no-one expects Legal and General to go bust – but no-one expected Scottish Amicable to either!
Thank you @TA for kindly updating this important piece, which now brings together your own tour d’horizon series on Broad Commodities and @Finumus’ recent excellent piece on trend following.
Couple of quick thoughts:
– In the US, TIPs’ current yields mean far higher real rates than for ILGs, but there’s FX risk to contend with there.
– MIFID etc has seemingly screwed up any chance of getting hold of a decent trend following fund in the UK for the retail punter with no provable background in financial services. All the good funds are available in the US, but not here 🙁
– Gold’s interesting. Moves to it’s own groove; unpredictable and idiosyncratic. Perhaps one to wait out and buy when cheap compared to its overall history, adjusted for inflation – i.e. not now, when in real terms it’s close to 1980 levels. Also, perhaps BTC has soaked up some part of the demand for the shiny stuff from Millennials. Buying gold miners doesn’t obviously look like a good way to leverage any inflation protection from gold, as costs in the sector have gone up as fast (or more) than the gold price. Was reading that in Australia it now costs miners A$1 mn p.a. for 2 experienced mine workers: A$250k (£120k) p.a. each for salaries, and the same again for overheads, relocation packages, travel allowance, private health care cover, NI and bonuses. Breaking even requires those 2 workers to mine an extra 8,500 grammes of gold p.a. between them on a 220 day working year at 8 to 10 grammes/tonne for high quality deposits; which is quite a tall order. On the other hand, the ratio of the gold miners’ market cap to the value of all above ground gold (212,000 tonnes of it now) is low by recent standards, esp. for the junior miners.
Thanks for the update TA.
A question for the community: is any particular broker much better than the others for buying and holding individual index linked gilts?
I’m thinking of the ease of trading (I know many are still telephone only) as well as accurate valuations (the old issue of clean versus dirty pricing).
If those issues disappeared, I’d give it a go, but as it stands I’m not sure if it’s worth the hassle.
@ TA & DH, I’ve been looking into holding US TIPS and how to mitigate the FX risk. Hoping someone can improve on the below:
The real yields on even the shorter dated bonds are 2%-ish rather than the 0.2%-ish currently on offer with our linkers. The best (least bad) way I can find to buy TIPS in the UK is to:
• Open a tax-sheltered account that lets you trade FX at mid, e.g. a SIPP on Interactive Brokers (so you don’t have to deal with the tax implications and don’t have to waste return on FX conversion fees)(note though that you have to pay ~£500/year for the SIPP, to a separate broker such as @SIPP).
• Convert some £ into $ at mid.
• Spend the $ on a TIPS ladder or similar, yielding ~US CPI +2%.
• Hedge the forward FX exposure as best you can.
The last part is the tricky part. Say you buy a TIPS maturing in a year’s time. If when it matures the FX has moved, if you haven’t hedged the FX then there’s every chance the FX movement will dominate the bond return (e.g. today you sell £10k to buy $12.5k, buy a TIPS which matures in a year with a change in CPI of 3% so a 5% return so you have $13.125k, but £/$ has moved from 1.25 to 1.35, so when you convert your $ back to £ you get 13.125/1.35 = £9.72k, ouch)
To hedge this, ideally you’d lock in an FX rate for the date the TIPS matured, but I don’t think that’s possible as ‘retail’?
A rough fudge would be to buy an offsetting lump of spot (normal) FX (so £+,$-), but this is prohibitively expensive to ‘roll’ each day forwards, even on Interactive Brokers.
On a spread-betting platform, you can buy forward FX on the nearest IMM dates (the ‘Futures’ dates, so roughly the middle of March, June, September and December) which is better solution – it’s more of a forward hedge (an FX rate fixed closer to the TIPS maturity date) and it’s less expensive to roll.
Better again you can buy ‘Micro’ forward FX contracts, M6B, which trade on the CME and are available through Interactive Brokers etc. Again they trade on IMM dates, but you can trade and then later roll them at mid (e.g. when the June contract approaches, you can simultaneously sell your June holding and buy the Sep holding). So cheap, though obviously not an exact date hedge. (note also that the spread between the June and Sep dates depends on the interest rate differential between the 2 countries, so currently with higher rates in the US you have to sell June at 1.2585 to buy Sep at 1.2595 which is effectively removing a slither of your returns each roll).
Would be intrigued what others think. It’s a bit of a fudge, but it should roughly work and be cheap to set-up and run (apart from the fee for holding your SIPP with Interactive Brokers)? Are there any better solutions?
@Vroom (40) I own the iShares ETF TI5G – 0 to 5 years TIPS hedged to GBP. Last time I looked effective duration was 2.37 years.
@vroom
Worth remembering that Index Linked Gilts are linked to RPI rather CPI, that’s a bonus of around 1% until ILGs change to CPI ( 2030 iirc)
There is a hedged version of a 0-5 year Tips Index fund, TI5G.L the duration is around 2 ½ years, a real yield of 2 ½ %
Suddenly I feel the urge to shoot the messenger…..
Thanks for the article. As part of an overdue portfolio review I have increased bond exposure towards 50% with slugs of IL bonds, funds and direct, and very uncomfortable it’s making me too.
Incidentally, the low cost abdrn short duration inflation linked tracker you identify on your low cost index funds list doesn’t seem to be available on the platforms I use but abrdn do have a short duration inflation linked bond fund which has a higher fee but best I could find to complement RLAAAM.
@Vroom #40: worth considering whether to bother trying to hedge the FX risk with TIPS.
The FX rate could go either way and, arguably, you’ll be as likely to win from changes to the rate as to lose out; although, obviously, it is still taking a punt, as no-one can say how the exchange rate will evolve over time.
The economic historian Adam Tooze makes the case today that $ and US Treasury safe haven status (and $ hegemony) might be longer lived in the future than one might expect:
https://open.substack.com/pub/adamtooze/p/chartbook-283-trump-trade-capital
There are a few different (average weighted) duration unhedged US TIPS UCITS ETFs to choose from.
Correct me if I’m wrong, but the second graph showing inflation vs 1 year real gold return (with the yellow and red lines) seems to show gold’s REAL return as never having dropped below 0%. That means it has always kept up with inflation and then some, indicating that it is in fact a good inflation hedge, no?
One question and one comment about holding TIPS directly (not through a fund):
1. What is the easiest way of investing directly in TIPS from the UK? I think Charles Schwab provides that facility, but I’m not clear who else does.
2. Any profit made on the sale/maturity of TIPS is taxable (unlike gilts). And, importantly, the profit is subject to income tax not capital gains tax. This is because TIPS are “deeply discounted securities” for UK tax purposes (gilts are not). This point has discouraged me from investing in TIPS.
Grateful for any thoughts on these points.
@JPGR #46: Your Q2: Whilst it’s true that profits on disposal of deeply discounted securities are chargeable to income tax rather than capital gains tax, and that an income tax profit arises where the discount exceeds a specified proportion of the amount payable on redemption with losses not usually allowable; can you not avoid all of these complications by just using an ISA or a SIPP, rather than a GIA, to hold the TIPS, whether or not they’re going to be held via ETFs or acquired directly as individual TIPS?
@ Elgan – for gold returns see the right hand axis which regularly drop below 0%
Thanks for this excellent article.
I hope this isn’t too simplistic a question, but is there still a place for a short-duration index linked bond fund in the defensive portion of a diversified portfolio – in the style of the Slow & Steady Portfolio (and particularly the q1 2019 update)? I’ve always had my defensive bond allocation split 50/50 between gilts and linkers (some Royal London Short Duration Global Index Linked Fund MRLAAM and abrdn Short Dated Global Inflation-Linked Bond Tracker Fund B) – thinking they had the benefit of some protection against (expected?) inflation. Now that you’ve explained in detail why these funds don’t protect against unexpected inflation, is the index-linking part of these a waste of time – might it be better to simply own gilts?
@DaleK you might be interested in this article if you missed it last month. I’m pretty sure TA/TI still see a place for index-linked funds as long as people understand the duration risk and the fact they aren’t perfect inflation hedges: https://monevator.com/short-duration-index-linked-gilt-fund/
I ask myself the same question about individual gilts but they still sound a little awkward in practice
Our 90/10 equities/cash portfolio has become mostly a 90/10 equities/linkers ladder portfolio now that linkers have a positive real yield. The ladder goes out 12 years and is designed to produce half our annual expenditure per year. The other half comes from dividends from the equities portfolio. At present though the dividends from the equities portfolio covers all our needs. As long as that continues and we can still get a positive real return from 12 year linkers I will roll forward maturing linkers.
Index linked gilts are great at the moment. Positive real return and next to no tax. I really cannot see any point complicating with TIPS or whatever. Beyond 12 years I am expecting the equities portfolio to outpace inflation, even if we do spend the dividends.
@ Delta Hedge – all good points (I think TIPS will inevitably exceed the discount you refer to), but my ISA and SIPP are maxed out with equity funds so I don’t have any capacity to put TIPS into my ISA or SIPP (if I could even figure out how to do that). So back to my first question: what is the best way of buying individual TIPS (not TIPS funds) in the UK?
@Naeclue – very helpful post, thank you. My strategy is similar to yours (albeit slightly more conservative), but I now wonder whether part of my “ladder” should be in TIPS. In principle I am content to add some extra complexity and tax inefficiency for the benefit of sovereign debt diversification. I also quite like the idea of having greater exposure to the US dollar.
@ DaleK – I think it’s an excellent question and one TI and I have been debating.
The real interest rate risk part of the linker fund equation overwhelmed the index-linked component of return this time around. Linkers, like other bonds, lost a great deal of value as yields rapidly turned positive from a position deep in negative territory.
The scale and speed of the switch was extraordinary. We shouldn’t think short-duration index-linked funds would always be a loser when inflation lifts off based on this single scenario. A gentler rise in yields from positive territory may turn out differently, though you’d still take some kind of interest rate hit.
My short-duration linker fund did do something. It shielded me from a worse loss than if I’d been in a longer duration fund.
But buying individual linkers and selling at maturity removes the interest rate risk issue.
That said, it adds complexity to managing a portfolio. It’s not exactly couch potato investing.
The S&S portfolio is meant to be a simple, accumulator’s portfolio (Notwithstanding the fact that owning a global equities fund would be simpler still but leave us with virtually nothing to write about).
So I don’t think I should be incorporating a rolling individual linker ladder for that model portfolio. But I do need to come up with a boilerplate piece that flags the issues.
BTW, which platform have you bought the abrdn Short Dated Global Inflation-Linked Bond Tracker Fund on? Someone mentioned it wasn’t on their platform earlier up the thread. I think Fidelity and Charles Stanley stock it, are you with someone else?
Hi TA. It was
‘abrdn Short Dated Global Inflation-Linked Bond Tracker Fund B (GB00BGMK1733) TCO 0.26% (OCF 0.12%, Transaction 0.14%)’
I couldn’t find so had to settle for the more expensive ‘ abrdn Short Duration Global Inflation-Linked Bond Fund Platform 1 Acc’ instead.
@TA – thanks for responding. I feel happier that they are still performing a role 🙂 I’ve got the abrdn Short Dated Global Inflation-Linked Bond Tracker Fund (GB00BGMK1733) on interactive investor and iweb.
@tetromino – thanks, I had already forgotten that article, and hadn’t seen the ‘availability’ update. Incidentally, I just called ii and they said they should be able to add the iShares Up to 10 Years Index Linked Gilt Index Fund (UK) (GB00BN091M63) early next week now (will be phone call dealing initially).
@JPGR, before Covid our investment portfolio was 60/40 equity bonds. As part of the bonds we did hold long duration US Treasury ETFs. We sold these at the start of Covid, switching to 90/10 equities/cash. I think holding foreign US Dollar denominated bonds is not unreasonable, but with only 10% in bonds I really don’t want any currency risk in there. Our equities portfolio (essentially world tracker weighted) has more than enough currency risk.
@DaleK. I have just checked. Yes I can see the acc. on Halifax and HL but it was the inc. variety I wanted. Ditto II. should have been more specific.
@TA
Why do you recommend holding individual bonds to maturity? Isn’t this the “myth of principle at maturity”?
@ Cafabra – if you want to eliminate the risk of your inflation-linked bonds dropping in price due to real interest rate rises then the only way to do that is to buy individual linkers and hold to maturity.
In actuality, your individual linkers still drop in price but you can avoid crystallising the loss by holding to maturity, unlike holding the equivalent allocation in a fund.
Do that (and reinvest your coupons) and you’ll earn whatever yield you bought in at plus the inflationary uplift.
@The Accumulator: clear, simple and superb advice. You really should start a blog!
@TA
Hmm, I’m worried now that I’ve misunderstood how bond investing works.
I read many articles from reputable sources about the “myth of principal at maturity” which convinced me that there was no benefit to holding individual bonds to maturity. It was my understanding that a bond ladder made of individual bonds held to maturity should produce the same financial result as a bond fund with an equivalent allocation.
Have I misunderstood the myth of principal at maturity, or have I misunderstood what you’re saying?
@ Cafabra – That’s right, in principle an individual bond ladder and a bond fund composed of the same underlying allocation achieve the same result (excepting costs) if managed the same way.
Except they’re not managed the same way. A bond fund sells its assets before maturity. Now that’s going to be more profitable than holding to maturity in a falling yield environment. But when yields rose, selling before maturity realised losses that swamped the inflation protection linker fund investors thought they were getting. The solution is holding to maturity.
There’s no reason you couldn’t get this service from a bond fund if it held its portfolio to maturity. A few ‘target maturity’ bond ETFs are now on the market but, IIRC, there aren’t any index-linked offerings yet. Last time I looked it was all US Treasuries and corporates.
@TA(62) I have read this explanation of bond funds not holding bonds to maturity many times here. I struggle, though, to understand why this should be the case for a passive fund. Would not an IL Gilt fund such as INXG seek to hold all the IL Gilts in issue, in proportion to the issue size, and have no need to sell before maturity? Now, I fully realise that the resulting duration on such a fund is very long and this itself is the reason interest rate risk more than dominates the inflation protection.
However, taking a shorter term example, this time with nominal gilts, such as IGLS 0-5 years gilts. At any time this would hold the full range of gilts that fulfil the maturity criterion. Shorter maturity gilts will mature and longer maturity gilts not initially included will meet the 5-year criterion and be bought. Some rebalancing within the fund may be necessary to meet the cap weighting. I realise that there isn’t an equivalent short-maturity ETF for IL Gilts, although I do own TI5G 0-5 years TIPS hedged to GBP.
All the passive gilt funds/ETFs I have looked at have been marketed on the basis of the index they follow, or the range of maturities they include. I don’t recall coming across any that seek to maintain a particular duration.
Hi DavidV,
I don’t think there’s any fundamental reason why funds can’t hold bonds until maturity, nevertheless they don’t. It’s a persistent feature of the tracker fund market from short to long maturities. The best explanation I’ve come across is that selling before maturity is quite a profitable technique in many but not all circumstances.
There’s clearly a gap in the market which is why target maturity / target date bond funds are slowly emerging.
I’d suggest that funds don’t market a particular duration because it’s hard to maintain precisely and possibly because there’s no demand for it. It seems to be enough to market your fund as short / intermediate / long. All the same, passive bond funds are also termed constant duration funds. An intermediate fund, for example, will maintain a broadly consistent duration over the short term. Over the longer term, the duration of a particular class of index tracker can change a fair bit as yields change e.g. low yields are associated with longer durations. Intermediate gilt funds are shorter duration now than they were when yields were near zero.
For nominal bonds, I actually want a constant duration structure. For index-linked bonds, I don’t.
@TA(64) Thanks for that explanation and additional information. Your article on building an index-linked gilt ladder (for constant real income) revealed to me that there were fewer gaps in maturity years than I had previously believed. Maybe I should now build my own short linker ladder for inflation mitigation rather than relying on the imperfect proxy of TI5G.
I have already dipped my toe in the water of buying individual low-coupon nominal gilts in my GIA with IWeb and that turned out to be easy to do online. However, my inflation mitigation is mostly in my ISA and SIPP on a different platform (HL), so I shall have to find out how easy it is to buy linkers with them.
I think you’ll find it relatively easy on HL as they’ve integrated linker purchases with their digital platform as per any standard investment.
Exhibit A: TI found it a piece of cake on HL and between you and me I’m amazed he makes it out of bed in the morning 😉
@TA
Thank you for your patience in replying to my comments.
My intuition tells me that a bond ladder and a bond fund which both maintain an equivalent duration should have the same interest rate risk. At the end of the day they’re both collections of bonds – whether they’re in a ladder or a fund, whether bonds are bought and sold at any given time, shouldn’t make any difference. The only thing that determines the interest rate risk is the duration. The gains/losses might be realised in different ways but the outturn should be the same.
I agree with your intuition but the objective here is to hedge against inflation.
The fund that sells up early in this scenario reinvests in higher yielding bonds that gradually erase the earlier capital loss (future yield changes notwithstanding).
The linker ladder does not sell up and if you roll its cashflows into new bonds then you benefit from those higher yielding bonds later.
Thus I am not saying a portfolio of individual linkers is a way to magic up extra return. But if you hold your individual linkers to maturity then you can be sure that the capital invested is returned to you as a fully inflation-linked sum.
The same is not true of funds because they sell before maturity.
If your objective is not to generate a stream of inflation-hedged cashflows then the difference is irrelevant. If it is, then individual linkers are the way to go.
@TA
Thank you for the clear explanation!
Just an update on the iShares Up to 10 Years Index Linked Gilt Index Fund (UK) (GB00BN091M63) which I had hoped interactive investor were going to add. Unfortunately they’ve just replied “we would be unable to enable this for trading as it is not supported by our Fund Provider”. Shame 🙁
@DaleK — Frustrating indeed! It’s a bit ridiculous that we have this ‘fund roulette’ aspect to choosing/living with a platform.
On the other hand, I always see the case for two platforms:
https://monevator.com/assume-every-investment-can-fail-you/
Another update to my comment #70 above. Looks like ii *will* makes the iShares up to 10 years Index Linked Gilt Index available. I had reported that they said they couldn’t, but it looks like I had inadvertently enquired about the ‘X’ class in error – doh!
ii’s latest update to me last week explained: “…we will be looking to offer the D class version once enabled and the ISIN for this is GB00BN091H11.”
I’ll confirm when I’ve been able to trade.
Final update on this – ii explain “I can confirm that the fund is available for trading over the phone. You will only be charged web commission for this.”