by Dewi John.
This month I’m covering a sector that most retail investors are unlikely to have invested directly in or, given recent performance, are likely to be tempted by: UK Index-Linked Gilts (gilts being UK government bonds). It is, by any standard, a bit niche and in “normal” times offers all the excitement of a polystyrene cup.
It is, however, an instructive lesson in sectors not always providing what it says on the tin.
Index-Linked Gilts—or Linkers—have never been an asset class high up on retail investors’ shopping list. But, given the name, you might think that they were a good hedge at a time when inflation is running in double digits. Which would be a mistake, as the sector is the second-worst performing over the 12 months to the end of September, falling 31.4% and beating only the highly volatile UK smaller companies. UK gilt returns have lost 23.7% over the same period. Government bonds, lest we forget, are often touted as a “risk free asset”. And—forgive the belaboured point—an inflation-protected risk-free asset to boot.
So, what is going on?
Linkers are indexed to the retail price index, unlike conventional bonds, which offer a fixed rate of interest. There being no free lunch in financial markets, investors must accept a lower coupon than their conventional equivalents in order to get this protection.
Linker prices are affected by two rate expectations: inflation and the Bank of England bank rate. If the latter is expected to rise, then the price of the linker, like any other bond, will fall. This is because higher rates reduce the value of future cash flows. The longer-dated the bond is (that is, the further out it’s due to be redeemed), the greater that effect. So longer-dated bonds will be more adversely affected that shorter-dated ones in a rising-rate environment.
To dampen inflation, central banks such as the Bank of England will raise base rates, causing the prices of longer-dated bonds to tumble. Current base rates are 2.5%, up from their low of 0.1%. The expectations are that the Bank of England base rate will rise above 4% by the end of 2022 and as much as 5.5% by July 2023.
This has a particularly egregious effect on UK linkers, as they have a much longer average maturity than, for example, the much bigger US inflation-linked market (known as TIPs): the average maturity of bonds in the FTSE Actuaries UK Index-Linked Gilts All Stocks Index is 21 years, compared to just eight years for the latter. Therefore, in comparison, the Global Inflation Linked Bond 12-month returns, which are heavily skewed to TIPs, has been -3.5%.
What’s more, UK index-linked bonds lag inflation. Index-linked gilts issued before 2005 have an eight-month lag, while those issued after have a three-month lag. Investors will make this back as inflation declines, but as it climbs—as now—it will add to the pain.
So, as long as base rates are expected to rise, there will be more pain for these funds. If rates stabilise while inflation rises, then they might be worth a look. But given that the Monetary Policy Committee is chasing inflation, that’s all very theoretical.
Table 1: Top-Performing Global Emerging Markets Funds Over Three Years (with a minimum five-year history)
All data as of September 30 2022; Calculations in GBP
Source: Refinitiv Lipper
This article first appeared in the November issue of Moneyfacts, page 17.
Refinitiv Lipper delivers data on more than 360,000 collective investments in 113 countries. Find out more.
The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.