Dealing with inflation on a fixed income

The picture is complicated slightly by a 2005 change to gilt contracts, with holders of securities issued earlier than this entitled to redeem them at current values. More recent issues have no such security.

‘Existing index-linked holders look set to be the biggest losers from the successful implementation of the proposed reforms,’ notes Capital Economics’ Samuel Tombs.

‘Both coupon payments and the redemption value of index-linked gilts depend on RPI inflation. So a lower rate for RPI inflation would cause index-linked gilts to be worth less [in nominal terms] than they otherwise would have been.

‘If the reforms are passed, then the market price of index-linked gilts would fall, causing real yields to rise,’ he adds.

‘That said, market prices may already reflect the risk that these inflation reforms are passed. For example, 10-year index-linked gilt yields rose by five basis points after the announcement of the consultation on RPI reform on 18 September.’

MRB adds that even from a fundamental basis, it is hard to locate much value in either inflation-linked gilts or treasury inflation protected securities, however.

‘With any upward pressure on nominal yields in the next year likely to come predominantly via real yields, inflation-protected securities will underperform conventional government bonds.

‘Despite more aggressive monetary policy support from major central banks, the need for inflation-protection is minimal on a six to 12-month horizon.’

Puntillo says he is finding good opportunities in longer-dated Latin American local currency index-linked sovereigns however, as inflationary expectations yo-yoed. In particular, he said he had been adding to his holdings of Mexican index-linked debt. ‘Brazil is offering 4%, Mexico at the long end you are getting 2.5% to 3% and Chile 4% real yield,’ he adds.

‘There are in effect two positives – the real yield and a good rationale that at some point down the line inflation will begin to pop up in these countries. Mexico we like [particularly] at the long end – curves are very steep and you get to lock in a large real yield [for cheap].’