When to buy index-linked bonds

Elevated levels of inflation have rarely been out of the headlines for the past two years, yet UK index-linked gilt (government) bonds have had a torrid time of it. The average fund in the Investment Association UK Index Linked Gilts sector, for example, fell 41.8 per cent over the two years to the end of October, according to Morningstar. This seemingly counterintuitive outcome is partly because inflation-linked bond prices depend on inflation expectations rather than actual inflation, and more significantly because linkers tend to be highly sensitive to interest rate increases due to their long maturities.

So while a disinflationary period may not sound like the most sensible time to buy inflation-linked debt, the prospect of peak interest rates, among other factors, means some professional investors argue that there is now a good case for this asset.

For one thing, real yields on 10-year index-linked gilts have risen from -3 per cent to 0.6 per cent over the past two years. “That is a huge move – they have gone from being essentially uninvestable a few years ago to being fundamentally attractive,” argues Chris Clothier of CG Asset Management, which will launch an inflation-linked bond fund on 15 November.

“You can now earn a positive real return – after inflation – from index-linked bonds. We are concerned that we may be entering an era of structurally higher and more volatile inflation, so it’s great that investors can buy assets backed by the government that, held to maturity, will beat inflation. While inflation is falling, we can’t be sure that there won’t be a resurgence. We are nervous about the high levels of inflation in private rents and that wage growth could stoke [broader] inflation. And if interest rates fall that ought to be good for index-linked bonds.”

The managers of Ruffer Investment Company (RICA), meanwhile, have added to US inflation-linked bonds even though longer-dated linkers were the biggest detractors from the trust’s performance in September. “Towards the end of [that] month, we decided to take advantage of these falls to add to US Treasury Inflation-Protected Securities (Tips), allocating 5 per cent of the fund’s capital to 10-year bonds offering real yields of nearly 2.3 per cent at what we deem very good relative value,” they explained. “A darkening economic reality, combined with tight monetary policy in the UK and US will ultimately cause a great, and quite possibly sudden, reversal of the market moves over the first eight months of 2023. When it comes, this should benefit [US and UK linkers].

At the end of September, Ruffer Investment Company had 11 per cent of its assets in overseas index-linked bonds, 6 per cent in long-dated inflation-linked gilts and 1.8 per cent in other types of UK linkers.

Wealth managers also think it may now be a better moment to put money into index-linked bonds. “It now looks like central banks are close to peak rates and this should be good news for bonds, including index-linkers,” says Richard Carter, head of fixed interest research at Quilter Cheviot. “Inflation-linked bond yields in both the UK and US markets are around 10-year highs. Falling inflation is not so good, but it has already been largely priced into markets.”

Laith Khalaf, head of investment analysis at AJ Bell adds that “it’s certainly a better time to be considering [investing in these] than it was in 2021 [when] the price of index-linked bonds was so high the yields on offer were below the rate of inflation”.

Bonds in general now have quite attractive yields so could be a hedge against weaker economic growth and/or volatility in equity markets, even if they haven’t performed that function effectively in recent years due to the impact of interest rates rises.

Reasons to hold back

If yields on nominal bonds rise dramatically, as was seen in late September when concerns over higher-for-longer interest rates took hold, yields on inflation-linked bonds will rise too. And as bond prices move inversely to yields, they will fall.

Index-linked bonds can be volatile, in particular longer-dated linkers. “It’s not simply a case that rising inflation means better returns,” cautions Khalaf. “Insurance and pension funds gobble up inflation-linked gilts irrespective of their price, which further distorts the market. That is a reason to be cautious about the market, along with the fact that, from 2030, index-linked gilts will no longer be linked to retail price index inflation but to the generally lower CPIH [consumer price index (CPI) plus housing costs] inflation. This should already be reflected in prices, but that depends to some extent on how efficient the market is.”

Carter says that while it’s a better time to buy index-linked gilts than in recent years, the best time “is usually when central banks begin cutting interest rates – as long as inflation expectations are not falling too fast at the same time”.

Some longer-dated UK linkers recently offered yields above the rate of CPI inflation of 6.7 per cent. The rally seen in recent days, fuelled by hopes of a UK base rate cut next summer, has pushed yields lower. But whether or not they turn out to be a good investment depends on what inflation turns out to be over their term period.

You also need to consider whether the prices of linkers are good value relative to non-index-linked gilts. A way to do this is to look at the ‘breakeven rates’ – the rate of inflation that would mean the return from an inflation-linked gilt matches that of a conventional gilt with the same maturity.

“If inflation turns out to be above this [level], the index-linked gilt provides better returns, and if inflation fails to hit the breakeven rate, the conventional gilt pays better returns,” explains Khalaf. “Over five years, the current breakeven rate is around 3.5 per cent, according to the Bank of England (BoE). The central bank’s projections see CPI falling to 3.4 per cent over the next year, 2.2 per cent the year after and 1.9 per cent the year after that. So index-linked bond prices over this time frame probably reflect inflation being higher than the BoE is expecting, but not by a huge amount. The breakeven rates also assume that you hold to maturity, while many investors may actually draw on the cash beforehand, at which point they are subject to a market price.”