Never mind deflation - be prepared with Index linked Gilts

Over the past year UK Index-Linked Gilts has been the fourth best performing IMA sector according to Trustnet data as of 20 April, one of only four sectors to make a positive return with 0.3 per cent. Only UK Gilts, Global Bonds and Money Market have done better.

Bond sectors have done well due to the decline in equity markets.

Gilts, which returned 9.7 per cent over the year to 20 April, outperformed index linked partly because pension funds are reluctant to buy the latter, according to Paul Rayner, manager of the Royal London Index Linked Gilt Fund, the best performer in its sector over this period. He said that pension funds are reluctant to buy index linked Gilts as the economy weakens and fears of deflation grow.

On Tuesday the Office for National Statistics reported RPI inflation fell to -0.4 per cent in March, down from 0 per cent in February. There was a large downward pressure from housing with the main effects coming from house depreciation, mortgage interest payments and, to a lesser extent, buildings insurance.

But Rayner does not expect a deflationary spiral such as took place in Japan to occur in the UK because central banks in western economies have reacted much faster to address issues, putting in place quantitative easing measures. He adds that if given a fiscal boost, UK consumers are more likely to spend than their Japanese counterparts.

Ultimately the government’s quantitative easing programme is likely to create more inflation than it wants, with Rayner anticipating that RPI inflation could return to 3 per cent by early 2010. This is similar to the view held by GaveKal Research chief economist Anatole Kaletsky.

Speaking at Tuesday’s Association of Investment Companies Conference for Directors he noted that deflation is much easier to deal with from a political perspective, as cutting rates is more acceptable than raising them. He also notes that governments can counter deflation by measures including an increase in public spending and credit guarantees.
 
Kaletsky anticipates rising inflation next year. 

Rayner also argues that now is a good time for investors to buy index linked Gilts as going forward these offer very good value. He also notes that as inflation should pick up in the longer term due to quantitative easing programme, it is a good idea to buy protection while it is still cheap.

He said although deflation has been priced into these index-linked Gilts they are still at their cheapest level for around five years. Index linked Gilts have been very expensive for the last three years but due to their cheapness should be considered both by pension funds and retail investors.

The price of these bonds has already improved after the government announced in March that it would include index linked bonds in its asset purchase programme.

Rayner has recently added index linked Gilts with maturities of up to ten years saying these are among the cheapest with falling inflation priced in. He also thinks that the Bank of England is likely to buy index linked Gilts with a maturity of up to 10 years.

The average duration of the fund’s portfolio, however, is 13 to 14 years even though it is slightly underweight index linked Gilts with the longest maturities. Rayner decided to take profits on these when they rallied.

The fund has been very underweight index linked Gilts which mature in 2011 and 2013 as Rayner said the shortest are most affected by the current falls in inflation.

Meanwhile other investors are starting to buy index linked Gilts. The government’s index-linked bond auction for the £1.1bn 2020 issue on 26 March was 2.75 times over subscribed in contrast to the Gilt auction the day before when the government failed to place all of the December 2049 4.25 per cent issue, causing spreads to widen.

And with the government expected to increase issuance to around £200bn, Gilt spreads are widening further.

Institutional investors favouring index linked Gilts include Tom Beckett who manages the PSigma Balanced Managed Fund of Funds.
 
He recently said: “We have also been committing new money to Corporate Bonds, now weighted at 8.6 per cent, and index-linked Gilts, presently 7.8 per cent. We are not putting new money into Gilts, presently weighted at 4.75 per cent, because we believe that sovereign bonds are probably overvalued in the medium term.”

John Pattullo who manages the Henderson Strategic Bond and Preference & Bond funds recently said he is concerned about the potential reflationary consequences of quantitative easing and has bought index-linked gilts.

In addition, last month Barclays Capital said in its monthly report that it prefers to be overweight index linked bonds rather than nominal ones, as breakevens (the difference between yields on benchmark 10-year government bonds and yields on inflation-linked bonds) were likely to continue to widening due to fears quantitative easing will increase inflation .