Wealth manager says index-linked gilts are more complex than many investors think

News - Funds

Written by Ray Clancy

Wednesday, 21 July 2010 09:22

There are a lot of myths and misconceptions surrounding index-linked gilts and investors are in danger of misjudging such a complex security, a leading wealth manager is warning.

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, says HFM Columbus investment director Rob Pemberton.

He adds that 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 include believing that the rate of interest paid out changes with RPI. He says this is not strictly true, and 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.

Another is that the gilt will return RPI plus its coupon (normally 2.5%). Pemberson says this is 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,’ he explained.

‘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,’ he added.

He says it is not true that coupons on ‘linkers’ are low so they are not a good investment because most of the gain comes from the indexation of the capital over the term of the bond.

It is also not necessarily true that because yields are low, you are better off in conventional gilts. ‘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,’ he explained.

And it is definately not true that you can’t lose money in index-linked gilts. ‘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,’ he added.

He also thinks it is debatable whether index-linked gilts have performed much better than conventional gilts. ‘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 3% 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,’ he said.

Finally he reckons it is probably not true that because inflation has picked up, now is a good time to buy index-linked bonds. ‘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.’