Are these UK index-linked bonds the best way to protect against inflation? UK index-linked gilts have been under pressure following the Brexit vote, which triggered even further best investments to protect against inflation in gilt yields.
In recent years, the majority of managers have held an underweight position in duration based on their view that UK are yields are too low, but longer-dated gilts continued to outperform short-dated gilts, hurting their funds’ performance. However, despite the persistent lack of inflationary pressures and further delays to interest rate rises in the UK, the sector is among the top performing niches of the fixed income universe over the longer term, largely because of ‘liability-driven’ allocations from large pension funds. The current outlook for the sector remains fairly positive on the back of heightened inflation expectations, driven by weaker sterling and the Bank of England’s extremely loose monetary policy. High levels of debt and prolonged Brexit negotiations might also make it difficult for the Bank to increase interest rates by much to control it.
Retail Prices Index The most common monthly indicator of inflation. It measures the prices of a representative sample of household goods and services. The higher the duration the more sensitive the bond is to changes in interest rates. This also means that benchmarks for this market such as FTSE Actuaries UK Index-Linked All Stocks, and thus the passive funds tracking them, come with very high duration, typically above 20 years. After such a strong performance in UK index-linked gilts, and with interest rates still low, the Bank of England could react to a further increase in inflation by raising rates quickly. This would cause long-dated bond prices to fall sharply and offset any inflation protection.
On top of that they are now a lot more expensive – all trade above par value with negative real yields. This means if investors hold this gilt to maturity, they are guaranteed to lose some of their capital in real terms. Taking above factors into consideration, investors should be better served by an experienced active fund manager who has the flexibility to adjust fund duration according to prevailing market conditions. Two managers who rank highly are Paul Rayner and Craig Inches who run the Royal London Index Linked fund. They’ve maintained and actively managed an underweight duration bias for the past few years, positioning the portfolio for a steepening in the UK yield curve by an overweighting in 0-5 year maturities and underweighting in bonds with maturities of more than 15 years. Their stance stemmed from the managers’ expectation of a gradual rise in UK bond yields.