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HFM Columbus warns about misconceptions surrounding index-linked gilts

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Myths and misconceptions surround index-linked gilts and investors are in danger of misjudging a complex security, warns HFM Columbus investment director Rob Pemberton.

In particular, Pemberton says there is a danger that investors take too simplistic a view as to their worth as an inflation hedge and see them as a no lose investment that offers capital protection and a guaranteed return above the retail price index over whatever time period they are held.

This concern is especially relevant today in light of the disappointing decision by the NS&I to cease selling the very popular three and five year index-linked savings certificates.

A popular misconceptions about index-linked gilts is that the rate of interest paid out changes with RPI. This is not strictly true – it is the underlying principal that changes with RPI which results in a higher interest rate payment when multiplied by the bond’s coupon rate.

It is also generally not true that the gilt will return RPI plus its coupon (normally 2.5 per cent. This would only be true if the bond was bought at par and held to maturity. Pemberton says what investors need to concentrate on is the real yield, which is the return that will accrue over and above RPI inflation between purchase of the bond and its maturity and depends on the current market price of the bond. In practise, the bond frequently is priced much higher than par such that the real yield on the bond is frequently far less than the coupon. Currently real yields on most index-linked gilts are less than one per cent and negative on short dated issues.

Another myth is that coupons on “linkers” are low so they are not a good investment. This is not true because most of the gain comes from the indexation of the capital over the term of the bond.

Some people believe that because yields are low, they are better off in conventional gilts. However, this depends on the level of future RPI implied by the fixed interest market and is measured by the “breakeven level” which is the difference in yield between index-linked and conventional gilts with the same maturity. Currently the market is assuming that inflation over the next 14 years will annualise at 2.9 per cent. If you think it will be higher you buy the linker; lower and you buy the conventional.

Pemberton says it is definitely not true to say you cannot lose money in index-linked gilts. If real yields rise then capital values of existing bonds will fall and given the long duration of many linkers this could be very damaging. The individual may have to hold them for a very long time, maybe maturity, until the capital is restored.

It is debatable whether index-linked gilts have performed much better than conventional gilts. Over the last ten years they have produced an almost identical performance in index terms. On a short-term basis, conventionals have outperformed linkers by nearly three per cent in 2010. This shows that changes in real yield are a more important returns driver for linkers than short-term inflation data.

Pemberton says it is probably not true to say that because inflation has picked up, now is a good time to buy index-linked bonds. Real yields are low so the bonds are expensive in this respect, whilst the recent pick-up in inflation may well prove to be somewhat of a blip rather than a long-term trend. Index-linked gilts should be treated as a “file and forget” asset in a well diversified long-term portfolio. Tactically now is probably a poor time to buy linkers given the potential for loss should gilt yields rise.

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