UK index-linked gilts: inflation-linked bonds explained

What is a UK index-linked gilt?

A UK index-linked gilt is a government-issued bond that adjusts its nominal coupon payments and final settlement repayment to meet accrued inflation. In theory, this means that the bond’s coupons and final settlement amount retain their real (ie inflation-adjusted) value over time, thereby protecting your investment against the corrosive effects of inflation.

This makes index-linked gilts a preferred security as a response to rising inflation, because it has low risk of defaulting.

As a result of the level of risk, the expected returns are also low.

Learn more about government bonds

Is a UK index-linked gilt an inflation-linked bond?

Yes, a UK index-linked gilt is an inflation-linked bond. Much like Treasury Bills in the US, these bonds are issued by the UK government, and because the value of the gilt’s coupons and principal (the sum of money that the issuer of the bond is borrowing and repays to the bondholder when it reaches the maturity date) depend on an inflation index, they’re inflation-linked.

The first modern inflation-linked bonds, or ‘linkers’, were issued by the UK in 1981. It was issued by single price auction, and indexation was to the General Index of Retail Prices (RPI). The gilt’s ownership was initially restricted to pension funds and institutions writing pension business. This first issuance totalled a nominal amount of £1 billion.

How do index-linked gilts work?

Index-linked gilts work by benchmarking their coupons and principal repayment amount against an inflation index Gilts issued by the UK government use the Retail Price Index (RPI) as their benchmark.

Coupons are paid on a semi-annual basis (ie twice yearly). The coupon amount you’ll get with each payment will be determined by how much the inflation index used as its benchmark has moved.

The adjusted coupons and principal enable investors to dedicate a portion of their portfolio to an asset that can be used to hedge against inflation risk. This is the risk that an asset, particularly those earning a fixed income, will lose value as inflation destroys the purchasing power of each payment. We look at this in greater detail below.

How the adjustment to coupon and principal amounts are calculated for each bond are set out in its corresponding prospectus. All recent prospectuses are available on the UK Debt Management Office (DMO) website.

What is an indexation lag and why is it important?

An indexation lag is the amount of time between the period over which inflation is measured and its reflection in the coupon payment. This happens primarily because time is needed to collect, compile and publish inflation data.

Depending on the date of first issue, index-linked gilts have different indexation lags. All index-linked gilts first issued before 2005 have an eight-month indexation lag, while those issued from 2005 have a three-month indexation lag.

The two different indexation lags have different ways of calculating adjustments. The exact calculations are complex; but they can be downloaded from the DMO website.

The indexation lag is important because it protects against inflation for the last interest period of its life cycle. For gilts, it’s the last six months. During the final stages of the interest period, inflation will not be reflected in the bond’s returns.

Bonds and inflation risk: how does inflation affect bonds?

The rise of inflation usually spells bad news for bondholders. This can be attributed to two things:

• A bond’s fixed coupon payment amount become less valuable to investors when money loses its purchasing power
• Central monetary authorities like the Bank of England (BoE) often react to high inflation by raising interest rates. As interest rates and bond prices are inversely related, higher interest rates result in a lower market price for the bond (if the bondholder wants to sell)

These two factors are the main elements of inflation risk. This is the risk that an asset, particularly those earning a fixed income, will lose value as inflation destroys the purchasing power of each payment.

For this reason, those looking for assets that retain their real value over time often consider UK government-issued index-linked gilts as a hedge against inflation risk.

Are index-linked gilts the same as Treasury Inflation-Protected Securities?

Both are inflation-indexed bonds, so they’re similar, but not exactly the same. The three main differences between each type of bond are: the issuing government, the way coupon adjustments are calculated, and each bond’s respective benchmark inflation index.

• Index-linked gilts are issued by the UK government, Treasury Inflation-Protected Securities (TIPS) are issued by the US Treasury
• In the case of gilts, adjustments are made to both the coupons and the principal repayment amount. In the case of TIPS, the primary adjustment is done on the principal amount, and this reflects in coupon amounts as they are derived from the principal amount
• TIPS are benchmarked to the US Consumer Price Index (CPI), whereas UK gilts are benchmarked to the UK Retail Price Index (RPI)

Bonds vs inflation-linked bond ETFs

Getting exposure to bond ETFs or inflation-linked bonds works differently to traditional bond ownership. Bond ETFs require the power of pooled capital to buy a selection of bonds. By contrast, when you buy and own a bond, you receive the coupons directly, and get repaid the principal amount at maturity.

Before buying shares in a bond ETF, you should understand what assets it holds and what the fund’s particular characteristics are. It’s also important to note that, unlike traditional bonds, bond ETF shares never mature or repay a principal amount on the value of your share purchase.

• ETFs are often passively managed, and therefore have relatively low fees when compared to actively managed investment funds
• Inflation-linked bond ETFs track a bond index, so you can get wide exposure to several bond variations from a single position
• Like holding actual bonds directly, inflation-linked bond ETFs can act to diversify a stock portfolio, thereby mitigating inflation risk
• Inflation-linked bond ETFs are frequently dividend paying, meaning that the coupons the fund receives from the bonds it holds are distributed to shareholders on a regular basis. However, the value of these will vary depending on the rate of inflation and can’t be seen as fixed income investments. Inflation-adjusted principal repayments from the held bonds may also cause these to fluctuate, if principals are paid instead of being re-invested

Learn how to trade in ETFs

How to trade index-linked gilts

When trading bonds, you speculate on the price movement by going long (buy) if you think the price will rise or go short (sell) if you think it’ll fall.

When using our platform, you’ll trade on the price movements of inflation-linked bond ETFs using derivatives like CFDs. Alternatively, you could opt to trade the government bonds futures market instead, using the same derivatives.

To trade our selection of bond markets, follow these steps:

1. Create an account or log in
2. Choose to trade using CFDs
3. Select your opportunity
4. Determine the size of your position and take steps to manage your risk
5. Open and monitor your position

Note that CFDs are leveraged products, which means you’ll only need a fraction of the full trade value as your deposit to gain exposure to an underlying market.

It’s important to take necessary steps to manage your risk because as much as leverage amplifies your profits, it also magnifies your losses. This means you stand to lose more than your deposit.

Our available UK index-linked gilt and US TIPS ETFs

Here’s a list of some of the UK index-linked gilts and US TIPS ETFs that you’ll find on our platform:

iShares £ Index-Linked Gilts UCITS ETF

The iShares £ Index-Linked Gilts UCITS ETF investment fund offers exposure to diversified UK gilts, to provide investors with a total return for both ultra-short gilts to those with a maturity date longer than 20 years. They also consider both capital and income return, which reflects the performance of the Bloomberg Barclays UK Government Inflation-Linked Bond Index, the Fund’s benchmark index (Index).

Launched on 1 December 2006, the ETF has £919 million in assets under management spread out across 32 holdings.

Lyxor UCITS ETF iBoxx (GBP) Gilt Inflation Linked

The Lyxor UCITS ETF iBoxx (GBP) Gilt Inflation Linked fund tracks the financial performance of the FTSE Actuaries UK Index-linked Gilts All Stocks index. The inception date was 13 October 2016, with over 40% of this ETF tracking 25-year+ maturity gilts, while a quarter tracking 15- to 25-year maturity gilts.

At the time of writing, there were 32 holdings in the ETF, with a total of £76 million assets under management.

US Treasury Inflation-Protected Securities (TIPS) ETFs

Investors seek exposure to the US Treasury Inflation-Protected Securities (TIPS) ETFs as protection for the declining purchasing power of their money as a result of high inflation. TIPS track the Consumer Price Index (CPI) and their principals rise with inflation and drop in deflation.

Instead of their yield increasing when inflation goes up, TIPS adjust their principal amount to maintain their real value. This ability makes TIPS a low-risk investment, which affects the interest rates returned to investors.

Here’s a list of more ETFs that you can trade with us:

• Barclays TIPS 1-10 UCITS ETF (UBTP)
• Lyxor Core US TIPS DR UCITS ETF (TIPA)
• SPDR(r) Bloomberg Barclays U.S. TIPS UCITS ETF (SPTIPS)
• iShares $ TIPS UCITS ETF USD (TPSA)
• iShares $ TIPS UCITS ETF USD (IDPT)
• iShares $ TIPS UCITS ETF USD (ITPS)
• iShares USD TIPS UCITS ETF (ISITPG)
• iShares $ Tips 0-5 UCITS ETF (TI5G)
• iShares $ Tips 0-5 UCITS ETF (TP05)

Index-linked gilts summed-up

• An index-linked gilt is a UK government-issued bond that adjusts its nominal coupon payments and final settlement repayment to meet accrued inflation
• Index-linked gilts are inflation-linked bonds because the value of the gilt’s coupons and principal are dependent on an inflation index
• The relationship between inflation and bond is closely tied to one another, with fixed bond repayment being less desirable when money loses its purchasing power as a result of inflation
• You can trade index-linked gilts with us to diversify your portfolio to a fund that has low risk
• Check out our list of available UK index-linked gilts and TIPS ETFs to get exposure