|These are the best protection you
can buy against inflation. But you don't get much of a return
Index-linked bonds (ILBs) are a sort of inflation-proofed
government bond. The key feature is that the interest rate is not
fixed. Instead, the margin over inflation is fixed.
We call these things 'index-linked' because their interest payments
and capital repayments are linked in some way to inflation. And
inflation is measured by an index. The usual definition of inflation
in the UK is the increase in the RPI (Retail Price Index).
How does it work?
Best start with an example.
Suppose you invest £10,000 in a new issue of
a 20-year 1% index-linked bond issued at par. In the first year
you will receive interest of 1%, or £100.
Suppose inflation in the first year is 3% (the RPI
increases 3%). Then in year 2 your interest will also increase 3%.
So you will receive £103.
Suppose inflation in the second year is 4%. Then in
year 3 your interest will increase (again) by 4%. So you will receive
£107.12 (remember compounding).
And so on.
But there's more. The bonds are redeemed after 20
years, and the redemption amount will be increased by all the inflation
over the previous 20 years. So if the RPI has increased by 3% per
annum that compounds to 80.61% and you will receive £18,061.
The general idea is that the purchasing power of your
investment will be protected whatever happens to inflation and the
coupon (1% in this case) is real income you can safely spend without
cutting into your real wealth.
Should we invest in them?
Difficult! We've only got room to make a few general points.
- This is a serious asset class, unlike some of the
junk mentioned on this site. You should consider it quite carefully,
particularly if you are both rich and risk-averse.
- Inflation is a real threat to money savings.
These instruments take the best shot at eliminating that threat.
(It's not perfect, because over a long period of time the RPI
may diverge from your own personal inflation - the increase in
the cost of things you actually want to buy).
- There may be a small tax advantage for high
tax payers (as compared with conventional bonds) because ILBs
deliver more of their return in untaxed capital gain and less
in taxed interest.
- By eliminating a lot of risk you have also
eliminated a lot of return. Current net-of-tax real yields on
IL bonds are about 1%. 1% on £1million is £10,000.
If you have £1million we are not sure you will consider
£10,000 per annum worth getting up in the morning for.
- Equities also offer some protection against
inflation. If you own a share of a widget factory and inflation
takes off, at the end of the day you will still own the same share
of a widget factory. And it may have been able to match its prices
to inflation and hold its percentage margins, which means it has
preserved its earnings - and therefore its value - under inflation.
- Cash also offers some protection, at least
to systemic inflation, because interest rates will go up to compensate
lenders for the real erosion in their capital values. That's how
the high-inflation Latin-American economies used to work.
We recommend you go through the Foundation course that leads you
to your preferred asset allocation between cash and equities. Then
evaluate IL bonds against your 'solution' to see if they feel like
an improvement. If they do, then buying them will be the right decision
You have a choice between Index-Linked Savings Certificates
(issued by National Savings) and Index-Linked Gilts (issued by the
Government). You may need help understanding the numbers (which
are quoted in an opaque way that suits traders but not investors)
and be careful about tax.
The economics of IL bonds throw a strong light on some key investment
- the real returns you can expect from low-risk
saving are surprisingly low (1% - Yuk!);
- ..........which puts a much more positive
spin on risk premiums that also look low (if you get an extra
3% by taking equity risk you multiply your returns four times);
- .......which puts the issue of high product
management fees in context. If you pay 1.5% to someone else, what
do you think will happen to your returns?