A new-ish short duration index-linked gilt fund from iShares gives UK investors an easy way to hedge against inflation [1] – without taking on huge interest rate risk.
Now I realise that sounded like “schmargle bargle bumpty tumpty” to some readers.
So today I’ll explain as succinctly as I can why this new iShares fund should be good news for everyday UK investors like us.
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Update: 30 April 2024 – Very happy to confirm that this fund IS available to invest in with some major platforms, partly as a result of this article. So you can ignore the ambiguity below. However you may need to ask your own broker to add it to their platform before you can invest in it. Anyway, I’ll update this article to make this all clear when I get some time.
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What’s that you say?
‘Should be’ good news?
Ahem – yes.
Alas there’s a catch. After a Monevator reader comment [2] got us and others excited about this new fund, it transpires the reason we hadn’t heard of it seems to be because it’s institutional-only.
Which means peasants like us can’t get at it.
I say ‘seems to be’ because I haven’t been able to confirm this yet.
Certainly I can’t buy it on any of my platforms. Nor can Monevator contributor Finumus.
What’s more, I asked two brokers early last week whether they could make the fund available – including a giant famed for its supposedly-excellent service – and I’ve yet to hear a definitive answer back.
The signs are not good though.
Either way, I still think it’s worth us sticking our grubby noses up against the glass and gawping at this new model: the iShares Up to 10 Years Index Linked Gilt Index Fund (UK).
That’s because in our lusting over it, we can get a refresher as to why index-linked gilts can be tricky investments, despite their obvious appeal.
Want to go deeper after today’s drive-by? Then click the links throughout to learn more about inflation and index-linked gilts. You’ll surely impress your co-workers, classmates, and Tinder dates.
- See the iShares factsheet [3] for all the pernickety details.
What is duration?
We’ll start with a necessary but quick recap – the meaning of short, long, and duration in bond jargon.
In this context, duration [4] refers to how much a bond price is expected to move as interest rates move.
- High duration bonds (/bond funds) will tend to fall a lot in price when interest rates rise – and vice versa.
- Low duration bonds (/bond funds) mostly shrug and say ‘meh’.
This may appear to be another example of the investing industry taking a perfectly sensible word – duration – and then using it to mean something only its disciples can understand.
However there is an underlying connection here, too.
Because of the mechanics of how bond income is paid out before the capital value of the bond is finally returned, there’s a close correlation between a bond’s stated duration and the length of time the bond has left to run before it matures.
Bonds set to mature ‘shortly’ – typically in the next few years – have a lower duration than bonds with many years left on the clock.
The same applies to bond funds. If they own a lot of short-dated bonds – those maturing soon-ish – they will have a lower duration than funds stuffed with longer-dated bonds.
By the numbers
Duration is expressed in the literature as a number.
For example if a bond’s duration number is 11 then it:
- Loses approximately 11% of its market value for every 1% rise in its yield1 [5]
- Gains approximately 11% for every 1% fall in its yield
Again, read our article on duration [6] for a much deeper explanation.
Why is duration so important with index linkers?
All bonds [7] are affected by changes in interest rates. Hence all bonds have a duration metric. They will perform differently in different interest rate movement scenarios.
However index-linked bonds are extra complicated.
That’s because the very reason you’d own linkers is to guard your portfolio against unexpected inflation.
And what happens when we see unexpected inflation?
That’s right, interest rates tend to rise in response. As we all have visceral experience of in recent years.
All bonds with high duration figures will suffer when interest rates rise a lot.
But with normal ‘vanilla’ bonds you might shrug and say, “them’s the breaks, I bought my bonds to guard against low growth / deflationary environments. I can’t expect them to do well when inflation takes off”.
But with linkers you’ll likely feel gutted.
That’s because you bought linkers to hedge your portfolio against unexpectedly high inflation. You got high inflation – and yet your (longer duration) linkers fell in price anyway.
It’s a rip-off! Where’s Martin Lewis when you need him?
Note though you are still getting your inflation protection. It’ll be there in the price return, as per the mechanics of how the linkers’ coupons and repayment amounts are adjusted higher [8] with inflation.
The trouble is with a high duration linker, the impact of rising rates can overwhelm the uprating from inflation, because inflation is leading investors to demand higher yields from bonds, driving down prices.
2022 and all that
It’s easier to appreciate how this can happen now we’ve lived through a definitive example.
The problem we faced in the run-up to the bond rout of 2022 [9] was that real interest rates were very low.
The ‘real yield’ (that is, what was expected after inflation) on some UK linkers was minus 2-3% at one stage.
This meant that even if you held such linkers until they matured, you could expect to earn a negative annual return of minus 2-3%!
That’s dreadful enough. But you might be thinking: “Huh? My longer duration index-linked gilts were down 50% at one point in 2022. That’s much more than a 2-3% decline!”
No doubt. What happened was instead of taking your negative 2-3% lumps for two decades, you got most of them in one whack as rates rose far faster than anyone expected – and bond prices duly sank.
This brought forward the baked-in pain. (And left index-linked gilts on positive real yields again, incidentally.)
Why short duration index-linked gilts?
Exactly why index-linked gilts were ever trading at negative real yields is a question for economists, academics, and fans of the stage illusionist Derren Brown [10].
I know the conventional explanation, obviously.
Talk to a pension fund manager and she might tell you she had to own index-linked gilts at almost any price, because it best matched the liabilities of her beneficiaries.
Also, maybe it wasn’t actually a given that either interest rates or inflation would go higher in the foreseeable future? Or at least not as savagely as we saw over the past couple of years. They’d stayed ultra-low for a decade after all, confounding many investors’ expectations.
Personally though, I don’t think there was much excuse for buying linkers on negative real yields of -3%.
Yes interest rates were near-zero for years. But this hardly seemed likely [11] to last – uninterrupted – forever.
Hence to me index-linked gilts seemed like a time bomb waiting to explode.
This isn’t hindsight speaking. We alerted Monevator readers about this risk many times, most notably in late 2016 [12]. We adjusted our model portfolio allocation accordingly, too.
Thank goodness in retrospect. And yet who knows? Maybe everyone was right in that almost anything could have happened, in other universes?
But then time rolled on. The dice fell as they did in this universe, and we got a crash that perhaps wasn’t quite ordained, but which did seem likely to happen, sooner or later.
DIY dilemmas
Anyway, pension funds and other institutions faced difficult choices in the near-zero interest rate era.
But private investors had an extra problem if they wanted to reduce interest rate risk while also owning index-linked gilts.
That’s because the best way to reduce interest rate risk – while still getting some lovely inflation hedging – from linkers is to own the shorter duration ones.
But not many private investors had the knowledge or nerve to buy individual short duration index-linked gilts in the market.
And unfortunately the only retail-friendly linker funds available were high duration.
For example, from memory the iShares core index linker ETF – ticker: INXG – peaked at a duration in the mid-20s! Talk about an accident waiting to happen.
INXG’s duration has come down a lot – to under 16 – after the big decline over the past two years. It’s still high though, when you remember what it implies about how the price will move with a 1% move in its yield.
With scant UK alternatives, for our Slow & Steady model portfolio my co-blogger The Accumulator chose to reduce duration by taking its bond allocation global.
He plumped for a currency-hedged, shorter duration fund that owns inflation-linked foreign government bonds.
This successfully reduced the S&S’s exposure to interest rate risk, thanks to the new fund’s lower duration.
But it did also mean this part of the portfolio was now hedging more against global inflation, rather than UK inflation. A reasonable proxy, but not ideal.
The iShares Up to 10 Years Index-Linked Gilt Index Fund
Instead we could opt for this new iShares fund next time, if we’re ever faced with the same challenge. (If we can buy it, of course…)
Launched in June 2023, the iShares Up to 10 Years Index-Linked Gilt Index Fund already has more than £700m to its name.
The ongoing charge figure (OCF) is just 0.13%. But the minimum investment size is £100,000. That might seem a dealbreaker – or even proof it’s for institutions only – except that sometimes factsheets quote high minimums but the figures turn out not to apply to retail investors. (I still have hope.)
Here’s the skinny on this short duration index-linked gilt fund, as of my writing:
[13]Source: iShares [3]
Don’t be concerned at the fund’s low number of holdings. Not from a riskiness perspective, anyway.
As the UK government stands behind all gilts, they are all assumed to have the same credit risk – extremely near-zero, because it’s assumed the UK government will never default. Hence you don’t need to diversify gilts like you would individual corporate bonds or equities.
The fund is very new as I say, so we don’t have long-term data. But iShares is a top-tier fund house and we can assume this fund will behave just as you’d expect shorter-term index-linked gilts to act, minus a small drag from fees.
One of these funds is not like the other one
iShares awards its new linker fund a ‘3’ risk level. The risk scale runs from one to seven, where low is less risky.
Its conventional index-linked fund2 [14] – which has a duration of over 18 – has a risk level of ‘6’.
Six is bigger than three. And so again, I don’t see why the short duration index-linked gilt fund shouldn’t be available to common folk like us.
The following graph shows how this lower risk playing out in practice.
The blue line charts the return of the iShares shorter duration linker fund since its launch in June. In yellow we have iShares’ standard longer-duration index-linked fund. Both funds are accumulation [15] class
Note which one gave you the smoother (less risky) ride:
[16]Source: Hargreaves Lansdown
Between October and December 2023, hopes rose that the rapid cooling of inflation would soon lead to much lower interest rates. But as 2024 has developed, markets have tempered their expectations due to somewhat sticky core inflation, especially in the US.
The graph shows how the longer duration linker fund reflects these changes in sentiment. Its value moves roughly 15% between the October 2023 trough to peak rate cut optimism in December. Its returns over this period are not driven much by inflation. Rather the move reflects changing interest rates.
In contrast, the iShares ‘Up To 10 Years’ linker fund is a sedate affair. Its much lower duration means it’s far less affected by changing interest rates.
Note you’re not getting something for nothing here. The real yields on shorter index-linked gilts are much lower than on longer-dated issues – less than 0.25% for linkers with less than five years to run versus a real yield of over 1% if you go 20 years out, according to TradeWeb [17].
It’s not that one fund is ‘better’ per se than the other fund.
It’s that they are doing different things.
What’s the alternative?
Now we know why owning a short duration index-linked gilt fund could be appealing. But what can we do instead of buying it – since for now it seems we can’t?
Create your own short duration index-linked gilt fund via a linker ladder [18]. Basically DIY your fund but only from shorter duration index-linked gilts up to ten years. We’ve written about how to create a linker ladder [19] [for members [20]]. You can expect a lower yield than with a longer-duration ladder, but less volatility.
Buy a longer duration index-linked gilt fund anyway. As I’ve said, the duration on the standard iShares’ ETF (ticker: INXG) has come down to just below 16. That’s still pretty wild if interest rates move. But (a) it’s lower than it was and (b) interest rates seem more likely to come down than to rise, so it could work in your favour as lower rates would push its price up. Crucially, real yields for index-linked gilts are positive right along the curve now. You’re not being charged a negative return for inflation protection like in 2021.
Invest in a lower duration global inflation linked bond fund that’s hedged back to UK pounds. As noted, this is what The Accumulator did with the Slow & Steady portfolio. Global inflation should roughly proxy UK inflation – though over the short-term especially they could diverge. Hedging protects you from currency risk and lowers volatility, but note currency moves are also a mechanism that corrects for inflation differentials. Which means there are scenarios where you might wish you owned such bonds unhedged.
Buy some US Treasury Inflation Protected Securities. I own a slug of the iShares US TIPS ETF (ticker: ITPS). It’s cheap and the duration is just under 7. My bond allocation is modest and only really there for some peace of mind in a crisis, so I’m happy with (unhedged) US dollar exposure. Often [21] – but not always [22] – the US dollar does well when markets crash.
Increase your cash allocation. I believe cash is the king [23] of asset classes. However it tends to get a bad rap in investment circles. You won’t retire early or rich if you only hold only cash. Strategically though, a chunky allocation to cash provides many benefits, from dampening volatility to dry powder for investing into sexier stuff during a bear market. You can think of cash as a short-term bond with a duration of zero. Allocating to cash therefore pulls down your overall average fixed income duration. Cash earning a decent interest rate can also help you with (imperfect) inflation hedging. You noticed how interest rates rose as inflation spiked over the past two years? Not by enough to match the worst of it, but enough to keep the lights on. (Obviously I’m talking about milder inflationary bursts here, not actual hyperinflation.)
This short duration linker fund should be available to us
When you consider all the bonkers stuff you can buy on your broker’s platform, there is no good reason for this particular fund not to be available to private investors.
I mean, two years ago ‘bonkers stuff’ included a long duration index-linked ETF from iShares that at that time was primed to crash 50% in a year when interest rates rose.
Such interest rate risk is massively lower with iShares’ short duration index-linked gilt fund. True we can also expect a lower return – because its holdings are on lower real yields – but that isn’t a risk, it’s pricing.
Who knows. Perhaps I’ll press ‘Publish’ on this post and immediately receive news from my broker that it has made the fund available. I’ll drop a note into Weekend Reading if so. Subscribe [24] to ensure you get it!
Until then we can only dream of owning such easygoing inflation protection.
(As well as asking ourselves some serious questions about when and why we began dreaming about funds, and whether it’s entirely healthy…)