You are here: cherry > Press releases for July 2010 > Red alert over index-linked gilts – HFM Columbus’ Rob Pemberton warns on myths and misconceptions

19 July 2010

Myths and misconceptions surround index-linked gilts, warns wealth manager HFM Columbus investment director Rob Pemberton – and investors are in danger of misjudging a complex security. “In particular, there is a danger that investors take too simplistic a view as to their worth as an inflation hedge - and see them as a ‘no lose investment’ that offers capital protection and a guaranteed return above the retail price index (RPI) over whatever time period they are held,” said Pemberton. This concern is especially relevant today in light of the disappointing decision by the NS&I to cease selling the very popular three and five year index-linked savings certificates. Popular misconceptions about index-linked gilts The rate of interest paid out changes with RPI – not strictly true, it is the underlying principal that changes with RPI which results in a higher interest rate payment when multiplied by the bond’s coupon rate The gilt will return RPI + its coupon (normally 2.5%) - generally not true. This would only be true if the bond was bought at par and held to maturity. What investors need to concentrate on is the ‘real yield’ which is the return that will accrue over and above RPI inflation between purchase of the bond and its maturity and depends on the current market price of the bond. In practise, the bond frequently is priced much higher than par such that the ‘real yield’ on the bond is frequently far less than the coupon. Currently real yields on most index-linked gilts are less than 1% and indeed negative on short dated issues (i.e. your return will be less than RPI if held to maturity) Coupons on ‘linkers’ are low so they are not a good investment – not true, because most of the gain comes from the indexation of the capital over the term of the bond. Because yields are low, you are better off in conventional gilts – not necessarily true. This depends on the level of future RPI implied by the fixed interest market and is measured by the ‘breakeven level’ which is the difference in yield between index-linked and conventional gilts with the same maturity. Currently the market is assuming that inflation over the next 14 years will annualise at 2.9%. If you think it will be higher you buy the linker, lower and you buy the conventional. You can’t lose money in index-linked gilts – definitely not true. If real yields rise then capital values of existing bonds will fall and given the long duration of many ‘linkers’ this could be very damaging. You may have to hold them for a very long time, maybe maturity, until your capital is restored. Index-linked gilts have performed much better than conventional gilts – debatable. Over the last ten years they have produced an almost identical performance in index terms. On a short-term basis, ‘conventionals’ have outperformed’ linkers’ by nearly three percent in 2010. This is maybe surprising but shows that changes in real yield are a more important returns driver for ‘linkers’ than short-term inflation data. Because inflation has picked up, now is a good time to buy index-linked bonds – probably not true. Real yields are low (even negative for short dated bonds) so the bonds are expensive in this respect, whilst the recent pick-up in inflation may well prove to be somewhat of a blip rather than a long-term trend. Index-linked gilts should be treated as a ‘file and forget’ asset in a well diversified long-term portfolio. Tactically now is probably a poor time to buy ‘linkers’ given the potential for loss should gilt yields rise.

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