Business is booming.

is it time to buy ‘linkers’?

Unlock the Editor’s Digest for free

One of the big expenses for the UK government this year has been how much it has had to fork out to the owners of its inflation-linked debt.

In this week’s Autumn Statement, the Office for Budget Responsibility predicted the UK would have to spend an additional £64bn on index-linked government debt on top of its March forecasts over the next four years — by virtue of the UK’s stubbornly high rate of inflation. 

With bumper payouts on these inflation-proof products set to continue, should private investors be buying it? And how do so-called “linkers” compare with conventional gilts? 

What’s available? 
The UK currently has 62 conventional gilts and 33 index-linked gilts in issue, according to the Debt Management Office’s website, with the latter making up about a quarter of the value of the UK’s debt pile. 

Both types are traded on the London Stock Exchange. They typically pay coupons on a semi-annual basis and can be bought across the UK’s largest do-it-yourself investment platforms, some of which, including AJ Bell and Interactive Investor, only facilitate index-linked gilt purchases by phone. 

Myron Jobson, a personal finance campaigner at Interactive Investor, said fewer than 5 per cent of gilt purchases on the platform this year have been for the index-linked versions.

“The inflation-adjusted element of index-linked bonds could have a significant impact on the returns, which is why retail investors typically prefer the certainty of holding a conventional gilt to maturity,” he said.

Hargreaves Lansdown, the UK’s largest investment platform, said its conventional gilt sales had risen more than six fold over the past 12 months, compared with a 72 per cent rise for index-linked gilts.

What’s the difference between standard gilts and linkers?
Conventional gilts redeem at £100 and your returns will be determined by the price paid for the bond as well as any coupons paid, which are fixed and stated in the title of the gilt. If the price of the gilt is lower than £100 when you buy it you will receive a profit at maturity. 

For index-linked gilts, both the coupon payments and the principal payments are adjusted in line with the retail price index (shifting to the consumer price index from 2030). Most index-linked gilts link payments to inflation with a three-month lag, with a handful issued before 2005 bound to an eight-month lag.  

The yield on index-linked gilts shows what return you will get in excess of inflation. For example, the index-linked gilt which matures in August 2028 has a yield of 0.45 per cent, meaning returns will be 0.45 per cent above the retail price index — which was 6.1 per cent for the year to October — over the next five years. Conventional five-year gilts currently yield 4.24 per cent. 

Line chart of Yield (%) for index-linked gilt maturing in August 2028 showing Real yields have surged in recent years

Which will deliver better returns?
It depends on whether inflation turns out to be higher or lower than market expectations. 

You can work out what market expectations are for inflation by subtracting the yield on index-linked gilts from the yield on a conventional gilt, which is known as the “break-even rate”, although it is complicated for gilts maturing after 2030, owing to the inflation index transition. 

The UK’s five-year break-even rate — the expectation for average RPI over the next five years — is currently 3.8 per cent. So if inflation is higher over that period, index-linked bonds would deliver better returns; if lower, you’d have been better off with conventional gilts.

If you sell the bond before it matures its price will depend on market conditions at the time.   

Line chart of Five-year UK break-even rate (%) showing Time your purchase with care

“Index-linked gilts are only suitable for experienced investors,” said Laith Khalaf, head of investment analysis at AJ Bell. “They are complicated. The data is not particularly widespread and it’s a market that is very dominated by institutional buyers that are not price sensitive.” 

How does the tax treatment work?
There can be tax advantages for buyers of both index-linked and conventional gilts.

Unless you hold the gilt within a tax wrapper, any coupon payments will be subject to income tax while the difference between the price of the bond when you buy it and when you sell it (or when it matures) is free from capital gains tax. 

This is why short-dated conventional gilts with low coupon rates have been so popular among wealthy investors this year as an alternative to cash: most of the returns can be paid out tax free.  

Khalaf said it is not clear, however, whether linkers or conventional gilts would prove more tax efficient, as it will depend on the terms of an individual bond, the price paid and the coupon level. 

Source link

Comments are closed, but trackbacks and pingbacks are open.