Linking Fortunes

20/01/2017 at 6:39 pm

Markets have begun to think about inflation again. In the US the new President is expected to contribute further towards existing pressure on prices; in Britain the weak pound has led to imported inflation as we saw again only this week. Talk in some quarters has turned, quite reasonably, to inflation protection, and specifically to index-linked bonds. This post is for anyone who is unsure what these are or how they work.

The UK was the first significant issuer of index-linked sovereign debt beginning in 1981. Details of the history and mechanics of the market are available from the Debt Management Office (DMO) website here. But the gist is as follows.

Gilts pay coupon interest semi-annually and repay principal on maturity. In an inflationary environment the real value of these interest and principal payments falls over time. So index-linked gilts, or “linkers”, have their coupon and principal varied in line with the Retail Price Index (RPI, the old measure of inflation, as distinct from the CPI measure which the Bank of England still officially targets).

Complicating things slightly there are two sorts of linker. The first, older variety lag RPI by eight months. This is to allow coupons to accrue on the basis of known values: a payment due in six month’s time will be based on the RPI print from two months ago (the additional month allowing for revision to the initial data release), so there is no uncertainty. Reflecting advances in technology, this type of gilt was superseded in 2005 by another which lags by only three months. This still allows for data revisions but by adjusting coupon and principal payments during accrual periods it follows RPI more closely over the life of the bond.

One further concept to mention is the breakeven inflation rate. This is the rate at which RPI would have to run to equalize returns between conventional and index-linked gilts of the same maturity. At present the benchmark ten-year linker yields -1.8% (these yields are always quoted in real terms). The ten-year conventional gilt yields 1.4%. So if RPI runs at 3.2% over the life of the bonds the linker will end up paying the same as the conventional. This tells investors about the relative value of the two types of security at different times, and about the market’s view on RPI inflation of course.

Index-linked gilts are the key securities for investors looking to protect themselves against UK inflation, as measured by the RPI. Of course in the event of RPI deflation then linker payments are cut rather than increased, which is something to bear in mind, as is the tax treatment: while gilt coupons are taxable as income any change in principal, including the full value of the indexation uplift, is completely tax free.

There are some index-linked corporate bonds in issue too. Like ordinary corporate bonds these pay a spread over government bonds to reflect credit risk and other things, but corporate linkers also track RPI in the same way as gilts. For individuals investing outside a tax wrapper, however, there is bad news. Unlike gilts, the principal uplift on corporate linkers is taxable – and taxable as income at that . . .

Of course the UK is not the only country to issue linkers. There is a sizeable French market, for instance. This offers bonds linked to two indices: the standard CPI and the CPI ex tobacco. Other eurozone countries also have index-linked government bonds in issue, which gives investors the opportunity to take views on respective inflation rates for different economies while bearing the same currency risk.

Some emerging market borrowers also issue linkers. Here, of course, currency volatility can be very high. But if inflation is imported on the back of currency weakness this benefits index-linked securities. In 2015 for instance the Brazilian real lost 49% of its value against the dollar. Year-on-year CPI peaked at 10.7%. And over the course of the year, the conventional government bond maturing in 2025 returned -8.1% while the 2024 linker returned 9.9%. For those interested in emerging market debt, then, there are times when indexation can be a helpful angle – where it is available of course.

Less exotically, the largest issuer of linkers is the US government by way of Treasury Inflation-Protected Securities (“TIPS”). The value of this market is currently $1.2trn (as against £603bn for index-linked gilts). TIPS seem to have found their strongest ever following at present. And not without reason: US breakevens from five years onwards are at about 2%, as against a 20-year average for CPI inflation of 2.2%. Should the US economy be entering a period of above average inflation, therefore, TIPS would offer value relative to conventional Treasuries – while giving dollar investors protection from the real-terms erosion of their wealth of course.

Index-linked securities are generally less volatile than conventionals, or thinking about this another way, even more boring. But there can be a place for dullness, or dependability, in portfolios. And in the event of a serious inflationary outbreak, linkers could well turn out to be the best bet in town. It is no coincidence that the British government first issued them on the back of a report from a committee that started work under Harold Wilson in 1977 – a short time after the oil crisis and a year over which UK inflation averaged 16%.


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