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Reality check: have index linked bond investors been benefitting from the wrong things?


Paul Rayner, Head of Government Bonds

12 October 2016

Over the last year, both conventional and inflation-linked gilts have generated returns in excess of 25%. Meanwhile, inflation has only risen by between 1% and 1.5%. Inflation-linked gilts have attracted inflows as sterling’s depreciation pushed up inflation expectations.  However, inflation has not been a driver of returns from longer-dated bonds.

In the wake of the Brexit vote, we’ve seen renewed quantitative easing (QE) and a rate cut from the Bank of England (BoE). The fall in long-dated yields to record lows increased defined benefit scheme deficits, in turn sparking renewed hedging activity – typically through buying long-dated conventional and inflation-linked gilts. But with the BoE also buying these bonds as part of its QE programme, the fall in yields has been exaggerated. In other words, it is the fall in real yields, not rising inflation expectations, that has been the main driver of index-linked gilt (ILG) returns.

There has historically been a reasonably significant positive correlation between real yields and inflation, based on the retail prices index (RPI). Current ILG yields are now far lower than we would expect for current inflation levels.

Rising inflation will push real yields higher, although we would expect further pension fund purchases to slow or dampen this effect. Rising inflation is likely to be positive for short-dated inflation-linked bonds, their longer-term counterparts are however, more vulnerable as inflation-induced gains will be wiped out by the rise in real yields.

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The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.

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