These are the best protection you can buy against inflation. But you don't get much of a return
Index-linked bonds (ILBs) are a sort of inflation-proofed government bond. The key feature is that the interest rate is not fixed. Instead, the margin over inflation is fixed.
We call these things 'index-linked' because their interest payments and capital repayments are linked in some way to inflation. And inflation is measured by an index. The traditional definition of inflation in the UK is the increase in the RPI (Retail Price Index). An alternative measure is the Consumer Price Index (CPI). The CPI is slowly replacing the RPI.
How does it work?
Best start with an example.
Suppose you invest £10,000 in a new issue of a 20-year 1% index-linked bond issued at par. In the first year you will receive interest of 1%, or £100.
Suppose inflation in the first year is 3% (the RPI increases 3%). Then in year 2 your interest will also increase 3%. So you will receive £103.
Suppose inflation in the second year is 4%. Then in year 3 your interest will increase (again) by 4%. So you will receive £107.12 (remember compounding).
And so on.
But there's more. The bonds are redeemed after 20 years, and the redemption amount will be increased by all the inflation over the previous 20 years. So if the RPI has increased by 3% per annum that compounds to 80.61% over 20 years and you will receive £18,061.
The general idea is that the purchasing power of your investment will be protected whatever happens to inflation. The coupon (1% in this case) is real income you can safely spend without cutting into your real wealth.
Should we invest in them?
Difficult! We've only got room to make a few general points.
- This is a serious asset class, unlike some of the junk mentioned on this site. You should consider it quite carefully, particularly if you are both rich and risk-averse.
- Inflation is a real threat to money savings. These instruments take the best shot at eliminating that threat. (It's not perfect, because over a long period of time the RPI may diverge from your own personal inflation - the increase in the cost of things you actually want to buy).
- There may be a small tax advantage for high tax payers (as compared with conventional bonds) because ILBs deliver more of their return in untaxed capital gain and less in taxed interest.
- By eliminating a lot of risk you have also eliminated a lot of return. Current net-of-tax real yields on IL bonds are about 1%. 1% on £1million is £10,000. If you have £1million we are not sure you will consider £10,000 per annum worth getting up in the morning for.
- Equities also offer some protection against inflation. If you own a share of a widget factory and inflation takes off, at the end of the day you will still own the same share of a widget factory. And it may have been able to match its prices to inflation and hold its percentage margins, which means it has preserved its earnings - and therefore its value - under inflation.
- Cash also offers some protection, at least to systemic inflation, because interest rates will go up to compensate lenders for the real erosion in their capital values. That's how the high-inflation Latin-American economies used to work.
We recommend you go through the Foundation course that leads you to your preferred asset allocation between cash and equities. Then evaluate IL bonds against your 'solution' to see if they feel like an improvement. If they do, then buying them will be the right decision (for you).
You have a choice between Index-Linked Savings Certificates (issued by National Savings) and Index-Linked Gilts (issued by the Government). You may need help understanding the numbers (which are quoted in an opaque way that suits traders but not investors) and be careful about tax.
The economics of IL bonds throw a strong light on some key investment themes:
- the real returns you can expect from low-risk saving are surprisingly low (1% - Yuk!);
- ..........which puts a much more positive spin on risk premiums that may otherwise also look low (if you get an extra 3% by taking equity risk you multiply your returns four times);
- .......which puts the issue of high product management fees in context. If you pay 1.5% to someone else, what do you think will happen to your returns?