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Index Linked Gilts - Value for Money?

by Ashley Clark, Director, March 2010

Industry commentators have been warning us that Index Linked Gilts are expensive at the moment. However, not everyone has the same opinion.

Even though the UK has a huge budget deficit, the Debt Management Office has still been selling gilts at low yield levels, which would ordinarily be unusual. This is particularly true for index-linked gilts where real yields are currently close to 1% or lower.

So, are index-linked gilts really that expensive? To decide, it is more relevant to compare the price to be paid with the price of alternatives. In the case of financial assets the first point to note is that the price of a short-term investment, i.e. the Bank of England base rate at 0.5%. This will have a strong influence on the price of all other assets.

The recent demand for index-linked gilts has driven UK real yields down to levels much lower than what is thought to be a minimum fair value level - the assumed average growth rate of the UK economy.

However, while real yields are low, it is wrong to think this implies investors are paying for inflation protection. The real yield on a 10-year index-linked gilt is currently 1% and the yield on a 10-year fixed coupon gilt is 4.1%. Therefore the breakeven inflation rate (a measure of the market’s assumption for inflation over the next 10 years) is 3.1%.

Therefore any argument that index-linked gilts are expensive must be expanded by saying that the bond market as a whole is expensive. Much of this is a consequence of the Bank of England’s quantitative easing programme, which because of the link between real and nominal yields has had an effect on index-linked gilts even though they were not included in the list of bonds purchased.

Consequently, for investors who wish to invest in government bonds, index-linked gilts can still be considered as being relatively attractive as they offer better prospective returns than fixed coupon gilts.

Investors who wish purely to protect themselves against inflation need to be aware that an investment into index-linked bonds, particularly longer-dated ones, will reflect the current low interest rate policies pursued by central banks and thus they will suffer if yields rise.