Misunderstanding About Inflation-Linked Bonds

Updated: Jun 22

There is a widespread misunderstanding about inflation-linked bonds, namely that they protect against inflation.

They don't. At least not always. And very probably not at the moment. Here's why.

I thought long and hard about writing this post because it all seems a bit rudimentary - a bond is essentially easy to understand. However, a friend of mine, one who worked in the investment industry most of his career, bought inflation linked bonds last year, thinking they would protect him against inflation - inflation that he correctly thought would continue to rise.

They didn't, nor were they ever going to - as indeed you'll see. If someone in the financial industry made this mistake, perhaps it was worth writing about.

Let's start with the evidence. Over the last 12 months, UK consumer prices have risen 9%. Therefore, to protect you against this rise, inflation-linked gilts would have to have also risen by 9% - or indeed by more.

Instead, they've fallen by 9%. WTF? A real return of -18%. WTx2F? And from their highs in early December six months ago they have fallen 21%, a real return of around -26%. WTtripleF? And -26% annualised is -45%. x4...

The next bit might be a bit too intricate for those not financially minded - but then that's nothing to be ashamed of in light of my friend's mistake.

The structure of an inflation linked bond is exactly the same as that of a non-inflation linked bond - aka a normal or straight bond. The difference is that in the case of an inflation-linked bond, the Treasury adds on to coupons and principle repayment whatever inflation has been during the relevant period - if a coupon payment a year from now would have been £100 without inflation, and inflation is 10%, you will receive £110.

Because the Treasury makes this adjustment in one case but not the other, the two types of bond must be priced differently - if inflation is positive as it normally is, the value of inflation-linked bonds will be higher than straight bonds i.e. their yields will be lower. Indeed, they are.

Last November, the 10-year inflation-linked gilt yield was -3.2%. This means that your return would have been the inflation rate minus 3.2%. You're already down, in real terms.

Then, the yield starts to rise, which it did - it's now a mouthwatering -2.5% - which pushes the bond price down in nominal terms. You're down more.

Inflation also starts to rise, which it did, so the bond price in real terms is lower still. You're down even more.

I think you get the point, even if the maths is not obvious.

The message? Be careful. Inflation-protected bonds can be good investments at certain times but they may not be in the current environment.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

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