Why we still hold index-linked bonds

Inflation in the UK appears to have peaked and be slowly falling. Does that mean it is time to ditch index-linked bonds?

To answer this question, we should start by busting a myth that index linked bonds (or “linkers”) generally are a default solution when inflation is rising.

Sadly, higher inflation does not guarantee positive total returns for all linkers. They are still bonds and bonds do not like inflation.

Equally, nor does lower inflation necessarily translate into falling returns. Ultimately, in nine times out of 10 UK linkers will behave the same as conventional gilts. The correlation between the two (in aggregate), is over 90% as shown in the chart below.

FTSE All UK Gilts vs FTSE All UK Inflation Linked

So, have they any value at all?

UK linkers can play a useful role within a diversified portfolio, depending on two important factors: “real yield” and “inflation breakeven”.

Factor 1: Real yield

At current valuations, UK linkers offer attractive positive “risk-free” real yields. But these vary depending on duration. At the time of writing, those maturing in 2029 (at the front end of the curve) offer the retail price index (RPI) + 0.75%. There is a high opportunity cost of not owning this asset. This contrasts with RPI of -3% for those maturing at the end of 2021.

Where you invest in the curve is often the most important consideration. The front end is driven by realised inflation versus expectations. Belly and long-end total returns are driven by duration.

Factor 2: Inflation breakeven

Inflation breakeven is the difference (or “spread”) in yield between a conventional bond and an inflation linked bond with similar maturity. When you buy a conventional bond, (to maturity) you buy a nominal yield. When you buy an inflation linked bond (to maturity) you buy real yield.

Nominal yield – real yield = expected inflation

At the short end, you will break even on the index linked bond if inflation matches expectations (and make money if it goes higher).

The current five-year inflation breakeven implies that RPI will average above 3.7% over the period. From February 2030 the reference index changes from RPI to the consumer price index (CPI), which has traditionally been lower. Assuming the historical 70bp spread between RPI and CPI prevails, this is equivalent to an average of 3% CPI. This contrasts with a Bank of England (BoE) target of 2%. We believe 3% is high enough and arguably too high given how aggressive the BoE has been.

As a result, we believe real yields are attractive but inflation breakevens are elevated. So currently we have a modest allocation to inflation linked bonds in the UK. We would require cheaper inflation breakeven to make it more meaningful. But there is another reason why we might want to hold these bonds.

What happens if the UK tips into a recession?

Monetary policy is designed to slow economic growth. What happens if it tips the UK into recession? That depends on how the BoE responses.

In a traditional recession, demand falls below supply leading to a rise in unemployment, which helps push down wages. This is disinflationary and in such an environment we might expect nominal gilts to perform better than linkers.

But there is an alternative scenario in which linkers suddenly become useful. Last year, central banks and governments shared a common enemy – inflation. Soaring energy bills and supermarket till receipts that made you wince meant there was a huge political cost of high inflation. Governments were fine with interest rates rising if it meant slowing inflation.

Today that picture looks more nuanced. In the UK where the base rate is now 5.25%, the impact is being felt and unemployment looks to be rising (though not hugely yet). The BoE itself estimates that one million households face an increase in their monthly mortgage of £500 or more by the end of 2026 – a hike of £6,000 a year. Plus, interest rates may begin to hurt voters who go to the polls next year.

It is easy to imagine a scenario where the BoE wants to continue tightening the screw on inflation, lifting interest rates further, but comes under pressure to reverse.

If it does not deliver as many hikes as priced in, the market may perceive the bank to be compromised. In that scenario the market might fear inflation sparking back upwards. Breakevens would widen because investors would want a greater inflation premium. At the front end of the curve, linkers would do better than nominals.

This is not the central case, but it is worth considering. An allocation to linkers can be a form of insurance.

It is risky to back just one view of where the economy, inflation and rates are heading. Linkers are a useful extra tool to have at your disposal.