Index Linked Gilts

Short Guide to Inflation-indexed Bonds

Summary

In this post I introduce you to inflation linked bonds and how they can be used by investors in an investment portfolio.

Introduction

Most private investors focus their attention on the equity market. It's exciting and offers the possibility of big gains, albeit at the risk of big losses or worse every now and then. Others are nervous of the equity market and prefer government or corporate bonds with their predictable (mostly) flow of coupons and pay-out (hopefully) on the maturity date. If your nervousness has developed into paranoia you may invest in gold as an insurance against war and pestilence. And if all of these options and choosing between them seems like too much then, of course, cash is a respectable investment although in some countries you may now be 'rewarded' with a negative interest rate. But there's a good alternative to all of these options and that's inflation-linked bonds.

What are Inflation-indexed Bonds?

There are many different kinds of bond. So called conventional bonds pay a fixed amount of interest or coupon every six months. On maturity they are redeemed at their face or par value. This amount is often referred to as the principal. You can find out more about conventional bonds in my book 'Quantitative Finance for Dummies' Chapter 4 'Defining Bonds and Bond Jargon'.

Inflation-linked bonds are slightly more complex. In the UK and US both the coupon and principal of inflation linked bonds are paid with an adjustment for inflation. So the amount paid to the investor on redemption of the bond is equal to the principal amount multiplied by the ratio of an inflation index between the issue date and the redemption date. This is what makes these bonds attractive to investors and particularly to pension funds who may have offered customers a pension with payments linked to an inflation index.

There are many differences between inflation linked bonds in different markets. A key one is the inflation index used. Here in the UK the Retail Price Index or RPI is used. This index includes mortgage interest payments and so it generally turns out to be higher than the alternative Consumer Price Index or CPI which excludes both mortgage interest payments and local taxes in the basket of goods used to measure inflation. That’s good news for investors in the UK but, as you can imagine, the UK Treasury has often muted changing to the CPI, but so far has never done so. Another difference between US inflation linked bonds (referred to as TIPS=Treasury Inflation Protected Security) and UK inflation linked bonds (often, thankfully, just called linkers) is what happens if the inflation index on maturity is less than the index at issuance. In the US investors are guaranteed to get their principal back even if the CPI has fallen during the period of the bond. In the UK that’s not the case so, in principle, you can lose capital from linkers in the UK. But negative inflation or deflation is extremely rare as you’ll see in the following section. The taxation of index-linked bonds varies from country to country and so you should always check with the relevant authority. Here in the UK the Debt Management Office, (DMO) which is the government agency charged with managing the government's debt portfolio has information on its website. In the UK the coupons are taxed as income whilst the gain from the indexation of the principal is not taxed.    

Indexation Lag

Inflation is a complex statistic to compute involving the price of a large basket of goods. It is normally issued well into the month following the one it refers to. This means that the coupons and principal of inflation linked bonds cannot be linked to the current month inflation. Most inflation linked bonds use a three month lag, so that, for example, the principal repayment will depend on the inflation index three months prior (and on the inflation index on issuance). So linkers and TIPS don’t perfectly protect investors from inflation but provided there isn’t a surge in the last three months of the investment period they do a very good job.  

Example

I'll follow an example given on the UK DMO website to illustrate the use of three-month lagged indexation: 

Calculate the dividend payable due on 17th December 2004 for a 2.5% index-linked gilt issued on the 5th November 2003

The coupon is £2.5 because this is a 2.5% bond and the factor of 1/2 is because it is paid as two dividends semi-annually.

Interpolation is used to calculate the reference RPI on 17th December from the December and January figures issued on the 1st of the respective months.

Now notice that the three month indexation lag has been used. The relevant RPI figures can be obtained from UK RPI Table giving:

All that's left is to compute the Reference RPI for 5th November 2003. The details are very similar to the calculation above and so the final result is:

And so the dividend has increased from £1.25 to £1.30 due to the effect of inflation. Don't forget that on redemption the principal paid back is augmented using a similar calculation.

History of Inflation

In the United Kingdom inflation is measured by the Retail Price Index as published by the Office of National Statistics Some historical data for this index since the second world war are charted below.

Data Source: Office of National Statistics

It shows some interesting features worth observing.  The main one is the huge peak in inflation in 1975 when it reached 25%. This is unimaginable today when the news as I write this (15th January 2020) is that UK CPI inflation has just dropped to 1.3% from 1.5%, significantly below the Bank of England’s target of 2%. With a 25% inflation rate the money in your wallet loses 25% of its value in a year and if your salary or pension does not rise accordingly you will become substantially poorer. However, in the past 25 years the inflation rate has been mainly on target with the exception being in 2008 when it briefly became negative during the global financial crisis. It is largely this shocking history of inflation and the fear of increased inflation that creates interest in the inflation indexed bond market. 

A Brief History of Inflation-indexed Bonds

Linkers were first issued in the United Kingdom in 1981. The UK was one of the first major economies to issue these bonds. Reverting back to the chart in the previous section you can probably see why: the 70s had seen exceptionally high inflation and investors in conventional bonds had made large losses. It took the US some time to catch and TIPS were only first issued there in 1997. In Germany the government was even more reluctant to issue inflation linked bonds but finally accepted them in 2006. Their reluctance to issue inflation-linked Bobl and Bund was probably due to the memory of the very destructive period of hyper-inflation and they didn’t want to send a message that investors needed inflation protection. The Bundesbank could handle inflation. But inflation linked bonds make economic sense because a country’s ability to repay an inflation-linked bond will increase during times of inflation because their tax revenues will be increasing. Typically, now 4% of the German Government’s debt issuance will be in the form of inflation-linked bonds. That compares with around 25% for the UK.

Scarcity and Liquidity

Linkers are a well established market with twenty-five 3-month lag issues available in maturities ranging from 2 years to 48 years. The issues range in size from about £7 billion to approximately £15 billion. In the US the Treasury offers an impressive facility for individuals to buy directly at TreasuryDirect and to even participate in the auctions used at issuance.

Breakeven Inflation Rate and Real Yield

Any investor or trader needs to be able to figure out whether a particular asset is a good buy or not. For index-linked bonds the key figures are the nominal or money yield rate and the real yield. The real yield of index-linked bonds is often quoted in the financial press and for UK linkers it varies between -2.5% for very short maturities to -1.8% for maturities over 40 years. The negative sign there is not a mistake! If you're still in a state of disbelief you can find these figures for the real rate of linkers in the Financial Times (FT) in the Companies and Markets section.

The chart below shows what is called the breakeven rate of inflation and has been embedded here from the Federal Reserve Economic Database or FRED. The number plotted is the nominal yield for a conventional 10 year bond less the real yield of a ten year index-linked bond (TIPS). If you think that inflation will be higher than this figure then buying TIPS will be a good idea compared with holding conventional bonds. Annual CPI inflation is currently running at 2.3% in the US and so TIPS look like a good deal.

In the UK currently (January 2020) linkers with a maturity greater than 5 years have a real yield (interest rate) of -2% and conventional bonds of similar maturity have a yield of around 1% and so the breakeven rate is 3% against an RPI annual % increase of 2.2% and so linkers seem to be poor value.
The calculations above assume a simple relation between real (r) and nominal yield (i) and the expected inflation rate π. More accurately you should use the Fisher equation which relates these numbers:

Fishers equation - named after the famous American economist

Most times there will be little difference but it's good to be aware.

Using Inflation-indexed Bonds in a Portfolio

The chart below plots the value of four common price indices against time, going back to 1987.

Sources: UK Land Registry, Yahoo Finance, Office of National Statistics, FRED

All of the indices have been rebased to equal 100 in 1987 to ease comparison. The stand out performer is the UK House Price which has systematically increased over several decades with the exception of a major interruption during the financial crisis of 2007/8. By comparison the Retail Price Index (remember, this is used to scale linker values) looks boring but that is its strength: it almost always increases and so indexing your savings to it is helpful. The FTSE 100 index performs well but has extended periods of volatility (rapid up and down movements) when on average it didn’t increase. The gold price can also be volatile and has extended periods of declines but the feature to notice is that it increased rapidly during the 2007/8 financial crisis despite a small blip downwards. Gold builds in a measure of protection against declines in other asset prices during periods of instability and uncertainty. I’ll be coming back to this in a future blog post. All of these indices have both attractive and unattractive features suggesting that a balanced portfolio should contain all of them, in other words property, equities, index-linked bonds and gold. This is especially true after taking into account transaction costs and taxation: potentially high returns from property can come with many drawbacks whilst the other assets are normally easy to buy and sell and need no maintenance.

The steadily increasing line for RPI in the chart above belies the price performance of index-linked bonds. This is shown below for a UK linker with a long maturity. It has over doubled in price in less

Source: www.fixedincomeinvestor.co.uk

than a decade and undergone considerable fluctuations especially in June 2016 (Referendum) and the second half of 2019 (General Election). Just as conventional nominal bond prices respond to nominal interest rates index-lined bonds move in response to real interest rates. So, index-linked bond prices will increase as real yield decline just as conventional bond prices rise with declining nominal interest rates. Expect then a linker such as 0.375% 2062 shown above to fluctuate a lot in price. Because real yields decline with increasing inflation you can expect index-linked bonds to rise in price when there is an anticipated future rise in inflation. For example, the steep rise in the linker price in the chart above during 2016 was probably due to an expected rise in inflation due to the drop in the value of £ sterling following the Brexit referendum. And in late 2019 the fear of higher inflation after the election due to higher government expenditure encouraged investors to buy linkers.

Index-linked bonds offer surprising opportunities in a well diversified investment portfolio. Indeed they can be more diversifying than conventional bonds and I'll investigate this further in subsequent posts. And as the chart above shows their performance needn't be dull even in times of low inflation. A big surprise!