Inflation-linked bonds – locking in a real yield

Inflation-linked bonds have grown in popularity since the post-pandemic rise in inflation, but is locking in a real yield as simple as it seems?

| 4 min read

Inflation-linked bonds (ILBs), also known as “linkers”, operate differently to nominal bonds – which typically pay a fixed rate of interest. ILBs offer a variable payment, linked to an inflation index, usually the Consumer Price Index (CPI) or Retail Price Index (RPI).

In the article, we share our outlook for bond yields over the short and long term, and explain our approach to investing in inflation-linked investments.

What are real yields?

Real yields (the rate of return above inflation) in the UK and US are positive across yield curve.

The “real yield” is the return after inflation is deducted from it. You can apply this to any investment, in any asset class. Real yields matter because returning 5% when inflation is 10% doesn’t grow wealth. To achieve real growth, your return needs to be above inflation. So, viewing returns from equities and bonds in real terms makes sense.

UK short-dated real yields are lower than long-dated. This reflects the market view that inflation will be higher in the short term. Over the long term, it is expected inflation will drift down towards target.

Across the Atlantic, inflation appears to be falling quicker than the UK, however nominal yields are still high. This has resulted in real yields across the curve in the US offering between 2% – 2.5%. The above data is correct as of 10/04/2024.

Our view on inflation-linked bonds

At present, we think nominal yields are attractive and market expectations on the future of inflation seem reasonable.

In terms of asset allocation, we are currently overweight on the fixed income asset class as we believe the case for owning equities over bonds has diminished as yields remain high. We have a neutral view on inflation linked asset class as we believe that current market expectations of future inflation are accurate.

The reason we like to have some exposure to direct inflation linked gilts in portfolios is that we can lock in positive real yields, with the downside being a return that, if held to maturity, is less than the nominal bond, but floored at the positive real return. As such, we like linkers for short maturities to provide within portfolios in the scenario that inflation does not abate as quickly as market expectations.

For asset managers who can hedge currency risk, we like short-dated direct treasury inflation protected securities (TIPS) vs inflation-linked GILTs. This allows us to benefit from high nominal government bond yields and lower US inflation (relative to the UK), achieving a more positive real yield if held to maturity.

If attempting to implement an inflation hedge through a passive ETFs, there are many different moving parts that will impact the total return, such as currency risk and interest rate risk. This has potential for high levels of volatility and an ineffective hedge against inflation.

Risks of inflation-linked bonds

While government inflation-linked bonds have very little default risk, there are other risk factors to consider before investing in linkers:

  • If a UK investor buys a direct TIPS, they pay investors in US dollar so they will experience currency risk when their returns are exchanged back to UK pounds. Of course, this could work both ways – for or against the investor. However, it is not providing a hedge against inflation for this reason.
  • Buy and hold direct strategies vs collective vehicles such as ETFs will behave differently, so consideration needs to be had for implementation.
  • If an investor buys a direct inflation-linked bond and sells before maturity, the return may differ from the expected real yield because of realised inflation and the interest rate sensitivity of the bond (duration)

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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