Stuart Steven

Little value in ‘extremely expensive’ index-linked debt

Stuart Steven

Recent outperformance from index-linked bonds obscures an extremely expensive asset class, with higher duration risk than conventional equivalents and negative returns if held to maturity.

Investors owning index-linked gilts have benefited as the fall in nominal yields has driven prices up; for most however, the rationale for buying these bonds was to protect themselves from higher inflation rather than seeking a capital gain. To provide a quick recap, these bonds offer both capital and interest linked to the RPI (retail prices index).

As such, these investors have been right but for the wrong reasons and they need to be aware of what they are locked into, in terms of long-term return profile and medium-term risks to capital.

Current pricing of index-linked bonds has little to do with inflation risks, particularly as we are in a period of a proven independent central bank in the UK with an explicit inflation mandate. Just consider the current implied breakeven rate, the average inflation required for index-linked bonds to produce the same total return as the equivalent maturity conventional gilt on a buy and hold basis. Given the index-linked market is now pricing in around 3.0%-3.5% inflation as far as 50 years out, this demonstrates just how expensive this market has become.

If you see conventional government bonds as expensive at present then, you really have to dislike linkers. The 2040 index-linked bond currently trades at a yield of -2.30%, so buy and hold investors will receive inflation less 2.30%. So, if inflation is 2.0% over the next 20 years, investors will receive a total return of -0.30% per annum for the period and a total real return of -2.30% a year.

Using the same assumptions, the conventional gilt will produce a total return of +0.97% per annum and a total real return of -1.33%.

 

While both markets are expensive, as highlighted above it is clear that index-linked bonds are significantly more overvalued: for the index-linked 2040 to outperform the conventional gilt, inflation would need to average 3.26% for the next 20 years relative to a Bank of England target of 2%.


In addition to more extreme valuations, index-linked debt also typically has more duration than equivalent maturity conventional gilts: the 2040 index-linked gilt has duration of 20 years for example so if yields rise by 1%, the capital price falls by around 20% (and vice-versa if yields fall 1%).

In comparison, the 2040 conventional gilt has a duration of ‘only’ 15 years: in that case, a 1% rise in yields leads to a capital decline of circa 15%.

In summary, there is no motivation for retail investors to own index-linked gilts. Even in the environment where inflation overshoots the breakeven rate required to outperform the conventional market, this would be a horrible period for conventional and index-linked debt given that all yields would reprice materially higher than current market levels.

While index-linked bonds might outperform in these conditions, they would be suffering significant mark-to-market capital losses, an unwinding of the gains government bonds have experienced over recent years as yields have trended to historic lows.

A further potential drawback for current owners of index-linked bonds in the UK is the uncertainty around how inflation is calculated. Earlier this month, chancellor Sajid Javid outlined plans to reform RPI to correct flaws in the way it is calculated — a change that will move the measure significantly lower in line with the alternative consumer price index including housing costs (CPIH).

With linkers currently aligned to RPI, it is unclear how this proposal will affect the future of these bonds as the gap between RPI and CPIH inflation tends to run at around one percentage point.

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Key Risks


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Tuesday, September 24, 2019, 9:34 AM