According to FE Analytics, the average fund in the IMA Index-Linked Gilts sector has returned 9.47 per cent year to date, over 1 percentage point more than any other sector.
Source: FE Analytics
Many suggested that the spike in yields in 2013, following the Fed’s suggestion that it would tighten monetary policy, signalled the end of a 30-year bull market in fixed income and that anyone who held bonds could expect capital losses over the coming few years.
At the same time, most expected equities to deliver far superior returns relative to bonds.
However, fixed income sectors such as IMA Gilts, IMA Sterling Corporate Bond and IMA Global Emerging Market Bond have comfortably outperformed the likes of the IMA UK All Companies and IMA Europe ex UK sectors this year.
One of the major reasons why the outperformance of index-linked gilt funds has been so surprising is because the rate of inflation in the UK has actually slowed, with official CPI figures falling to 1.5 per cent from 1.6 per cent last month.
Nevertheless, barring the SJP Index Linked Gilt fund, every portfolio in the 18-strong sector has returned more than 8.5 per cent so far in 2014.
The £120m Hermes Active UK Inflation Linked Bond fund – which is managed by Penni Coe – tops the sector with returns of 11.12 per cent; which means it ranks 64 out of all 2,456 funds in the IMA universe this year.
The Hermes offering is followed by AXA Sterling Index Linked Bond and Schroder Institutional Index-Linked Bond fund which have returned 10.95 per cent and 10.72 per cent, respectively.
Performance of funds vs sector in 2014
Source: FE Analytics
Richard Scott, manager of the PFS Hawksmoor Distribution and Vanbrugh funds, says the major reason why the IMA Index-Linked Gilts sector has performed so well is because it was an area of the market that was oversold at the back end of 2013.
“I have to admit that I would not have made the prediction at the start of the year that index-linked gilts would have performed so well,” Scott (pictured) said.
“There are two quite simple reasons for it. Firstly, gilts have surprised on the upside. However, index-linked gilts are far longer duration, which has disproportionally benefitted them.”Long duration assets are those that have the highest sensitivity to interest rates.
As many investors expected interest rates to rise as developed economies seem to be recovering, index-linked gilts were one area of the market that were sold heavily last year.
“The other thing I would say is that the current environment is difficult and uncertain,” Scott continued.
“I have just had a meeting with a UK manager and he was talking about the poor liquidity in the market and he said that was a reflection that no-one has any real conviction in any asset classes. In that environment, locking in a long-term return – even if it isn’t that attractive – is better than backing something you aren’t sure about.”
“In July, a 2058 index-linked gilt was issued and the initial issuance was supposed to be £4bn, but that was raised to £5bn due to demand and it was still £14bn over-subscribed. For the first time, the bonds were set at a negative real yield.”
He added: “Even though inflation hasn’t been a problem and could continue to fall, there is still that demand to lock in a return.”
David Thornton, senior investment manager at Premier, also admits he wouldn’t have predicted that index-linkers would have performed so well and, like Scott, he attributes that outperformance to the fact they are long-duration.
However, he points out that index-linkers have had a much more volatile ride this year than other fixed income sectors such as IMA Gilts, IMA Sterling Corporate Bond and even IMA Sterling High Yield due to that long-duration aspect.
While they have performed well, is this just mean reversion or should investors be buying funds from the IMA UK Index-Linked sector?
“We accept that we, and most other people, are not going to be able to accurately predict what will happen when the Fed stops QE,” Scott said.
“One possible outcome is that the authorities get a nasty inflation surprise, so buying index-linked could be a good idea.”
“However, this duration issue – which has been the major driver of returns this year – makes us nervous about holding index-linked gilt funds. That’s because in a situation where inflation picks up, you would expect long-bond yields to rise at the same time.”
Due to that concern, Scott is using the M&G UK Inflation-Linked Corporate Bond fund as while it aims to protect its investors against the rise in prices of general goods and services, it is inherently short-duration.
The £890m fund, which is run by Ben Lord, was launched in October 2010. According to FE Analytics, it has returned 15.07 per cent over that time; which is above the rate of inflation in the UK.
Performance of fund vs index since Oct 2010
Source: FE Analytics
It is a favourite fund of Square Mile, the investment research firm and a strategic partner of FE, for investors who want inflation-protection and holds their A rating.
“This is an interesting strategy which should provide investors with protection against UK inflation over the longer term, whilst offering something slightly different from standard government inflation-linked bond mandates,” Square Mile said.
The fund’s ongoing charges figure (OCF) is 0.7 per cent and it yields just 0.66 per cent.
Thornton agrees that investors need to shy away from traditional index-linked bond funds, but is still looking at portfolios which invest in sovereign debt.
“We don’t hold any at the moment, but we are looking at a couple which are shorter duration because we think that is the best way of playing it,” Thornton explained.
Two which are on his list are the AXA WF Global Inflation Bonds fund, which sits in the offshore universe, and the newly launched Standard Life Short Duration Global Index-Linked Bond fund.
