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Should investors avoid index-linked bonds after their “meteoric rise”?

26 October 2016

Plenty of investors think index-linked bonds will continue to be a prudent investment given rising inflation, but Hawksmoor’s Ben Conway is very cautious about the stretched valuations in the asset class.

By Gary Jackson,

Editor, FE Trustnet

The expectation that UK inflation will continue to rise in the coming months and may overshoot the Bank of England’s 2 per cent target is heightening the attraction of index-linked bonds for some investors, but Hawksmoor’s Ben Conway argues that they have now become too expensive to protect portfolios.

Figures published by the Office for National Statistics earlier this month revealed that the consumer price index (CPI) reached 1 per cent at the end of September, showing a sharp rise from August’s rate of 0.6 per cent. The jump was widely anticipated, as cheap oil and lower charges in hotels and restaurants caused prices to fall in the same month of 2015.

However, experts predict further inflation rises to come especially as the effect of the weak pound start to be felt. Bank of England governor Mark Carney has already suggested the central bank will tolerate a move above the 2 per cent target without tightening policy in order to help the economy.

UK CPI inflation since 1989

 

Source: Office for National Statistics

Rising inflation is generally bad news for bond investors; Quilter Cheviot head of fixed interest research Richard Carter points out that 10-year gilts with a yield of just over 1 per cent are “clearly unattractive” if inflation does pass 2 per cent as they would be offering a ‘real’ yield of minus 1 per cent.

“Indeed, gilt prices have fallen over recent weeks, partly due to worries about inflation. Other reasons for the decline include the weak pound, which may make foreign investors pause before buying sterling-denominated bonds; and also the perception that the government is about to embark on a borrowing and spending spree. There is also a concern that the UK could slowly drift into a weaker position as a borrower,” he said.

“However, we should not exaggerate the threat posed by inflation – the UK is not about to turn into Weimar Germany of the 1920s, when hyperinflation caused economic crisis and political instability.”

Amid this backdrop, Carter suggests that index-linked bonds – where their payments to investors are adjusted in line with the retail prices index measure of inflation – could be a prudent holding.


“In our model portfolios, we have been ‘overweight’ linkers and have recently been in a position to take some profits from their meteoric rise,” Carter said.

“The Bank of England cut interest rates to help the economy in the wake of the EU referendum vote, and there has been some talk among economists that it might do so again later this year. However, the market seems to judge a further cut in UK rates unlikely (in large part due to the inflation threat) and on this occasion we tend to agree with the market. We are slightly cautious on bonds.

“But again, it pays to take a balanced view and not be too extreme: we disagree with prophets of doom who forecast the imminent demise of the bond market. About $10trn has been spent by central banks on monetary stimulus since the financial crisis of 2008, and most of that has gone into the bond market. While central bank support continues, we see no reason to be extremely bearish on bonds.”

Performance of index-linked gilts vs conventional gilts and FTSE All Share over 5yrs

 

Source: FE Analytics

As the chat above shows, index-linked gilts have indeed witnessed a “meteoric rise” over recent years.

2016 so far has also been a strong period for linkers, after the FTSE Actuaries UK Index-Linked Over 10 Years index rose 36.96 per cent. Conventional gilts were up 19.39 per cent and the FTSE All Share gained 14.10 per cent over the same period.

Ben Conway, who co-manages the top-performing MI Hawksmoor Vanbrugh and MI Hawksmoor Distribution funds with Richard Scott and Daniel Lockyer, remains cautious on the outlook for index-linked bonds following their “truly extraordinary” run.


Conway said: “A confession: we haven’t really had any exposure to these assets in our portfolios so it would be nice if we had, but on the flip side our good performance has been achieved without having exposure to them and – as I’m about to demonstrate – these are the type of assets we don’t want to have exposure to.”

“They are assets that are expensive and will get more so; we don’t want to play that game.”

 

Source: Hawksmoor Investment Management

The fund of funds manager takes the example of an index-linked gilt that matures in 2068. It has a face value of £100 and pays a coupon of 0.125 per cent but is currently trading at a price of £275.

“The real yield on this is minus 1.9 per cent. What that means is, if you hold this bond to maturity, you see a real yield, that is after inflation, of minus 1.9 per cent whatever the inflation rate is,” he said.

“That negative real yield is not just confined to long-dated bonds. In fact, the real yield on all index-linked gilts is currently negative and they range from minus 1.8 per cent to minus 2.7 per cent.”

Conway says that for investors genuinely worried about inflation, the best instrument to buy is one that will pay off if inflation goes up. Index-linked gilts appear attractive on many fronts – they are issued by the government, do not carry much credit risk and the coupons and principle are explicitly linked to the rate of inflation.

“However, what sort of protection do you actually give your portfolio if you are guaranteed to lose money in real terms?” he concluded.

“If you want to buy these instruments to protect your portfolio from inflation you are going to either lock in a negative real yield if you hold them to maturity or you have to hope that someone else will come along and pay an even greater negative real yield for the privilege of owning these things. You would need to rely on these things getting more expensive and that is starting to edge into the realms of speculation rather than investment.”

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