By Chris Clothier, Co-CIO, CG Asset Management
In lots of ways, index-linked bonds are a perfect instrument for private investors to hold. When you buy a conventional government bond, and hold it to maturity, you know with certainty how much you will get back in nominal terms. But you have got no idea what that will be worth in terms of purchasing power.
Of course, when you buy it you can make a rough guess at what inflation will be over the life of the bond and often that guess will turn out to be pretty good. But as we have seen over the past couple of years that guess can be out by a long way. Conversely with an inflation linked bond you know exactly how much you will get back in real terms, that is to say after the effect of inflation.
Index-linked bonds work differently from conventional government bonds because the coupon (interest payment) and the principal (the amount you get back at maturity) rise with inflation. Because the principal is tied to inflation, and is a large source of an investor’s return, the coupon tends to be much lower than on nominal bonds.
Index-linked bond investing: why is the breakeven important?
An important concept when investing in index-linked bonds is the breakeven. The breakeven is the difference between the yield on a conventional bond and the real yield on an index-linked bond. If the conventional bond has a yield of 4.5% and an index linked bond, of the same maturity, has a real yield of 1% then the breakeven is 3.5%.
You can think of the breakeven as a market implied forecast for what inflation will be over the life of the bond. It is called a breakeven because if inflation did indeed average 3.5% over the life of the two bonds then you would be indifferent as to which you held. If inflation is higher, then you would do better owning the index-linked bond than the conventional and vice versa.
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What a lot of investors have found confusing is that returns on index-linked bonds in the UK have been negative over the past two years, despite the fact that inflation has been at the highest level in over 40 years. How come?
In late 2021, yields on 10 year index-linked bonds in the UK were around -3% and yields on 10 year nominal gilts were about 1%. The Bank of England started to raise interest rates and yields on 10 year nominal gilts rose sharply to stand at 4.25% today. Even though the country was experiencing the highest level of inflation in a generation, breakevens didn’t change dramatically. The market effectively said that inflation was transitory and inflation would soon return to normal. That meant that real yields rose almost as much as nominal yields and, since prices move inversely to yields, the value fell a lot.
Admittedly, investors who held index-linked bonds were better off than if they had held conventional bonds. Both suffered losses as yields rose, but index-linked bond holders were partially compensated because their final redemption amount was increased in line with the big inflationary burst.
Why bother at all?
Given that disappointing performance an investor might be forgiven for asking why they should bother at all? Well as ever, whether an investment is good comes down to the price you pay. When investors bought a 10 year index-linked at a real yield of -3% in 2021, if they held it to maturity they were guaranteed to lose 26% of their money in real terms. Today they stand to make over 6% in real terms. That is a huge swing.
Investors should not underestimate the value of inflation protection, especially if, as we believe, we are entering an era of structurally higher inflation. The deflationary tailwinds of the past 20 years – mostly due to globalisation and China’s integration into the global economy – have come to an end. In its place are structurally inflationary forces. The energy transition will require huge investment in energy generation and transmission infrastructure. Spending on defence will have to increase given the resurgent risks of war. Finally, in the face of cost of living pressures, labour is becoming more assertive and demanding a higher share of the GDP pie, after decades during which their share shrunk.
The risk of higher inflation is one reason to own index-linked bonds; the other is financial repression. The world is ever more indebted and those debt levels will need to be tackled. Governments and central banks will do this via financial repression: holding short term interest rates below the prevailing rate of inflation for several years. In turn this means that real interest rates will turn negative and the result of that is capital gains to the owners of index-linked bonds. But even if this doesn’t come to pass, the ability to protect purchasing power and earn a modest return with government back is not to be sniffed at.
About CG Asset Management
CG Asset Management was set up in 2001 and is an independent boutique investment house committed to wealth protection of clients’ capital by focusing on absolute return and inflation-linked sovereign bonds. Its unrivalled long-term track record is a testament to the academic rigour that lies behind its investment approach.
CGAM has a long pedigree of investing in index-linked bonds with its first purchases of UK Linkers through Capital Gearing Trust in 1992. CGAM manages £2.4bn in index-linked bonds across eight jurisdictions, including £500m in UK index-linked.
