Index-linked gilts: time to get out of linkers?

In the first of a four-part series of articles on investing in bonds, we explain how index-linked gilts work and consider their potential for investors.

Demand for index-linked gilts remains stubbornly robust, even in the wake of a stellar performance by inflation-fighting UK government bonds last year and with the cost of living set to rise at a slower pace.

‘Linkers’ are so highly sought-after, in fact, that at an auction last Tuesday Britain sold £700 million of the bonds maturing in 2047 at a real yield of -0.116% – with investors actually paying the government for the privilege to lend to it.

Not surprisingly, funds that invested in the asset class were the best performers of 2011, returning an average of 21.82% against a mostly miserable showing elsewhere. And while those gains are unlikely to be repeated this year, bond market participants and observers do not believe they will be lost, either.

How linkers work

Index-linked gilts are somewhat complex securities, and work as follows: when you buy conventional gilts from the government, it agrees to pay you a coupon at a set rate, until it returns your money at a specified date in the future.

But with index-linked gilts, the underlying principal – the bond’s face value – and the coupon change in line with the Retail Price Index (RPI), a measure of inflation.

All indexing – the linking of the gilts to the RPI – is based on face value rather than market price. This means that if you buy the security at a higher price than its face value, or ‘above par’ and hold it to maturity, there will be a loss in capital value.

Also, in the event of deflation, the principal and interest payments will be adjusted downward to reflect this, making conventional gilts a better investment.

Linkers are issued in auctions by the Debt Management Office, the government’s debt issuing arm, in which bidders need to be part of an approved group of investors to participate. They can, however, also be bought in the secondary market through brokers.

Enduring pension fund demand

Much of the demand for linkers comes from pension funds, which are compelled by regulators to hold them to match their assets to their liabilities, points out Marc Ostwald, strategist at Monument Securities.

‘In normal circumstances, if you had no one breathing down your neck, you would look at this and say: “Well, why would I want to buy into a negative yield?” he asks.

In light of such ‘regulated demand’, appetite for linkers will hold up, the strategist adds, especially as investors choose gilts over other asset classes amid the eurozone’s debt woes and fears over global growth.

‘At least... you are being compensated for inflation,’ Ostwald says, noting that not everyone will accept the Bank of England’s assurances that inflation will drop sharply this year. ‘Okay, you have to deduct a little bit for the negative real yield; but by comparison to the negative real yield in absolute terms on conventional gilts, it’s a lot better.’

The ‘flight to quality’

Should Ostwald’s outlook hold true, index-linked gilts funds may yet have a solid – albeit not superstar – showing this year as well.

The table above shows the ten top performing funds in the Investment Management Association’s UK Gilt and UK Index Linked Gilts sectors last year.

One of 2011’s top performers was Axa Sterling Index Linked Bond, a fund for institutional investors managed by David Dyer, which returned 23% versus a total return of 20% for the Barclays Capital UK Govt Inflation Linked index, a benchmark.

Dyer acknowledges that investors would have to be ‘very optimistic’ to envisage ‘anything like the performance’ seen last year, but stresses this does not necessarily mean the gains will be reversed.

Linkers are likely to continue enjoying the ‘flight to quality’ triggered by fears over the eurozone, he says, while the Bank of England could launch yet more batches of its inflationary ‘quantitative-easing’ stimulus programme.

He also asks how quickly inflation will return to the Bank’s target of 2% from its current level of 4.8%, if it does at all. ‘Any sign that it isn’t necessarily going to fall as rapidly as the Band of England predicts, then that would boost inflation,’ the fund manager adds.

The key risk to linkers, Dyer notes, is threat of a rehashing of questions over Britain’s coveting triple-A credit rating and its bond’s perceived safe haven status, as happened in early 2010.

A long, hard slog

Howard Cunningham, manager of the Newton Index-linked Gilt fund, another institutional vehicle, points out that linkers gained as poor growth expectations for the UK economy weighed on conventional gilts’ yields, which have an inverse relationships to prices.

And warning that Britain faces a ‘long, hard slog’ back to economic health, he says: ‘We’re not forecasting a sharp rebound in growth, this year or next, or possibly the year after.’

The manager agrees that it will be hard to replicate last year’s gains, yet notes that he also does not expect to lose them. ‘I don’t think it’s going to be a “mean reversion” trade, where we’re going to see similarly big losses this year,’ he says.

Cunningham, who also manages the Newton Long Gilt fund, in which there is a small linker position, points out that should real yields rise by about 30 basis points, investors could expect capital declines of about 4% on a portfolio of linkers of over five-year durations. ‘But then, over the course of the year, with the income you earn, I think even in that scenario you’d be looking at ‘plus or minus not very much as a return.’

He also cites the threat of a loss of confidence in UK debt as a risk to the securities.

‘If you go back to the beginning of 2010, our yields were like Spanish yields. And now clearly we’ve moved from looking like Spain to looking like Germany, in the eyes of bond investors,’ Cunningham says, pointing to the market's approval of the government's austerity programme.

‘I don’t think it’s likely that there’s going to be a backtracking in the next year or 18 months, but were there to be a populist change of tack, then that could be dangerous.’