The failure of index-linked bond funds to carry out post-Covid has actually been bothering me. What’s the purpose of this stuff in the event that they don’t really defend you from inflation? In the meantime, particular person index-linked gilts – appropriately used – are supposed to be a correct inflation hedge. However is that true?
Can we empirically show particular person linkers labored when inflation let rip?
First, some context. Our favoured linker fund holding at Home Monevator previous to the post-pandemic worth surge was a short-duration mannequin. That’s as a result of short-duration index-linked fund returns usually tend to mirror their bonds’ inflation ratchets, and are much less susceptible to cost convulsions triggered by rocketing rates of interest.
Longer length linker funds, in the meantime, obtained hammered in 2022 as a result of they’re extra weak to rising rates of interest. When charges soared, costs dropped so exhausting and quick that their bond’s inflation-adjustment aspect was rendered as efficient as wellies in a tsunami.
Hopefully you at the very least averted that destiny…
The weakest hyperlink(ers)
So it’s October 2021, and also you’re duly positioned on the shoreline, scanning the horizon for inflation, with ample assets invested in short-duration linker bond fund items.
Right here’s how our defences carried out as soon as the inflation Kaiju was unleashed:
Inflation versus short-duration linker fund
Index-linked bond fund is the GISG ETF. Information from JustETF and ONS. February 2025. NB. The linker fund pattern line was corrected on 18 Feb 2025.
Oh. As that calm-voiced announcer-of-doom on Grandstand might need intoned: “Inflation One, Passive Investing Defence Power, Nil.”
Or, in numbers extra applicable to an investing article, the annualised returns from October 2021 (when inflation lifted off) to year-end 2024 are:
- UK CPI inflation: 5.9%
- Brief-duration linker fund: 0.6%
Observe: all returns on this article are nominal, dividends reinvested.
In different phrases, this linker fund fell far behind rising inflation and posted real-terms losses over the interval.
Proper-ho. In order that was a studying curve.
Since then I’ve put a whole lot of time into researching particular person index-linked gilts, commodities, gold and cash market funds – all belongings fancied as providing a point of inflation safety.
Probably the most dependable needs to be particular person index-linked gilts. In spite of everything, they arrive with UK inflation-suppression built-in. Put your money in, and it pops out at maturity, with a price-adjusted enamel on prime. Buying energy protected!
All you should do isn’t promote your linkers earlier than maturity. Shopping for-and-holding prevents the sort of losses bond funds are weak to realising. Funds’ fixed length mandates make them compelled sellers when bond costs are down.
Excelente! However one factor was nonetheless nagging me. Did particular person linkers really ship on their inflation-hedging promise throughout the latest worth spiral?
Inflation versus particular person index-linked gilts
To reply that query, I simulated the efficiency of a small portfolio of particular person index-linked gilts utilizing worth and dividend knowledge from October 2021 to year-end 2024.
Then I pitted the person linkers in opposition to CPI inflation and GISG, the short-duration linker ETF mentioned above.
Right here’s the chart:
Information from JustETF, Tradeweb and ONS. February 2025. NB. The linker fund pattern line was corrected on 18 Feb 2025.
Okay, the person linkers (pink line) did higher than the fund however they nonetheless lagged inflation. The annualised return numbers are:
- Inflation: 5.9%
- Particular person linkers: 4.1%
- Linker fund: 0.6%
That’s nonetheless an unhealthy hole so far as I’m involved – like shopping for a peep-hole bulletproof vest.
Proving a unfavourable
Why did the person index-linked gilts lose cash versus inflation?
As a result of manner again in 2021 they have been saddled with unfavourable yields. That’s, the buy-in worth for linkers was so excessive that their remaining cashflows have been assured to sock you with a loss, in case you held them till maturity.
The most effective a linker portfolio held to maturity may do was restrict the injury in opposition to inflation. However that unfavourable yield drag meant it was all the time going to underperform.
However that’s a historic downside. At present index-linked gilts are priced on optimistic yields, to allow them to maintain tempo with inflation whereas sweetening the cope with real-return chocolate sprinkles on prime.
The opposite level price making is that my clutch of particular person linkers have been nonetheless prone to the downward worth lurches that troubled constant-duration bond funds.
The chart above reveals a giant dip in late 2022 when costs fell as rates of interest took a hike, as an illustration. Suppose Trussonomics and different traumas of the period.
These are solely paper losses to the person linker investor who holds till maturity or loss of life. Maintain quick and ultimately your bond’s worth will return to fulfill its face worth on redemption day (plus inflation-matching bonus within the case of linkers.)
In the meantime, the bond fund is flogging off its securities on a regular basis – profiting when costs rise and shedding once they fall. That was a really unhealthy design function throughout the post-pandemic inflation shock.
My particular person linkers’ worth dip was smaller than the fund’s largely as a result of I may select to populate my modelled portfolio with shorter-duration bonds. Brief bonds are much less affected by rate of interest gyrations, as mentioned.
Nonetheless, I questioned if I used to be being unfair to the fund. In spite of everything, linker funds beforehand gained in 2020 as cash flooded into the asset class.
One final probability for the linker fund
The subsequent chart reveals annual returns together with 2020, the yr earlier than inflation ran sizzling.
Index-linked bond fund is Royal London Brief Length World Index Linked M – GBP hedged. Information from Royal London, Tradeweb and ONS. February 2025.
Yep, 2020 was a superb yr for the linker fund. Rates of interest fell and its worth rose giving it a wholesome lead over inflation, and the person linkers. (Bear in mind the fund income by promoting bonds as costs rise. In the meantime, the longer common length of the fund’s holdings meant that it loved a stronger bounce versus my battery of gilts.)
There’s not a lot to see in 2021 – bar inflation engorging itself – however 2022 is the fund’s annus horribilis. It’s down 5.4% at face worth and 16% in actual phrases. (Horrifyingly, the long-duration UK linker ETF, INXG, was down 45% in actual phrases that very same yr.)
Total, incorporating 2020 does enhance the linker fund’s displaying. The annualised returns for the 5 yr interval 2020 – 2024 are:
- Inflation: 4.6%
- Particular person linkers: 3.7%
- Linker fund: 2.2%
It’s nonetheless not sufficient. For my part, the most effective linker funds out there have been a fail when inflation really got here calling. I personally held each GISG and the Royal London fund on the time and have become deeply disillusioned with them.
All change
The difficulty driving all this drama was that as inflation accelerated, traders demanded the next actual yield for holding bonds.
The typical yield of the simulated linker portfolio above was -4.2% in October 2021. It had risen to 0.5% by December 2024.
When bond yields go up, costs go down. And that exposes the deadly flaw in linker fund design from an inflation-hedger’s perspective – the out there merchandise are all the time promoting and even the quick length variations aren’t quick sufficient.
Maybe yields gained’t surge as violently in a future inflationary episode.
However I don’t see why I’d take the danger after I can now purchase particular person index-linked gilts on optimistic actual yields, maintain them to maturity, and neutralise that downside. Particular person linkers aren’t going to be slow-punctured by unfavourable yields from right here.
So I’ve ditched my index-linked bond funds. They have been higher in opposition to inflation than the equal nominal bond funds. However that’s not saying a lot.
There are different locations to retailer your cash so I’ll lengthen this comparability to probably the most fascinating and accessible of these various belongings within the subsequent put up.
Take it regular,
The Accumulator
Bonus appendix
In the event you’re curious about shopping for particular person index-linked gilts then these items will assist:
Are particular person linkers higher than linker funds?
At hedging inflation sure. At being extra worthwhile, no.
For the avoidance of doubt, I’m not saying {that a} portfolio of particular person index-linked bonds can magick up extra return than a bond fund containing exactly the identical securities.
What I’m saying is that the person linker portfolio is the superior inflation hedge when every bond is held to maturity. The design of fixed maturity bond funds mitigates in opposition to matching inflation within the short-term, however ought to present the same total return in the long term.
In the event you don’t care about hedging inflation then there’s nothing to realize by swapping your bond funds for a rolling linker ladder.
Mounted length index-linked gilt funds may additionally hedge inflation successfully, however they don’t exist.
UK inflation versus globalised inflation
It’s price mentioning that particular person index-linked gilts are linked to UK RPI inflation (switching to CPIH in 2030). RPI was increased than CPI throughout the interval in order that’s helped my simulated portfolio claw again some floor in opposition to CPI.
In contrast, the short-duration linker ETF, GISG, presently allocates 14% of its portfolio to index-linked gilts. The remaining consists of different developed market, CPI-linked, authorities bonds: 56% US, 10% France, 7% Italy and so forth. The purpose being that these different linkers don’t defend in opposition to UK inflation, although they do match associated measures i.e. inflation in extremely interconnected, peer economies.
Because it was, inflation in these different international locations was usually lower than the UK’s post-pandemic. I haven’t tried to calculate what distinction this made however I feel it’s another excuse to favour an index-linked gilt funding product when you may get it.
Particular person linker portfolio simulation
I didn’t need to lavatory the principle piece down with a wander by way of the weeds (effectively, greater than I have already got) however for the report I’ll now present my workings.
The person linker portfolio was constructed from three index-linked gilts, TIDM codes: T22, TR24, and TR26. Every gilt matures within the yr indicated by the numbers within the code.
When every gilt matures, the redemption cost is reinvested into the following shortest gilt. For instance, T22 is reinvested into TR24. I didn’t embody buying and selling prices for reinvesting dividends or redemption monies.
Relatedly, the efficiency figures for GISG and the Royal London fund are barely affected by their OCFs of 0.2% and 0.27% respectively. However I don’t suppose these prices made a significant distinction to the comparability over such a brief time-period. The differential is just too huge to be defined by fund charges.
