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Understanding index linked gilts

Gilts, bonds, and interest-bearing shares
Midsmartin
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Understanding index linked gilts

#400625

Postby Midsmartin » March 31st, 2021, 4:49 pm

I'm trying to get my head around this; apologies for the basic question.
Can someone confirm if I'm doing this right please?

Let's take TG51 as an example. issued 8/02/21; maturity 22/03/51

Current price roughly 184

Am I correct in saying that if I want to have £10,000 in today's money repaid in 2051 when I'm in my 80s, I would have to buy approx £18400 of TG51 today? (ignoring interest, and the change in RPI over the last month).

As a thought experiment: even if RPI rose tenfold in the next 30 years the result is the same in real terms - £18k spent today would get me £10k in 2021 money on maturity (though in nominal terms it'll have another nought on the end).

Have I got this right?

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Re: Understanding index linked gilts

#400628

Postby Alaric » March 31st, 2021, 5:02 pm

Midsmartin wrote:Have I got this right?


I doubt it. What you get as a return is based on the relationship between the RPI at issue and the RPI at maturity. Today's price is likely to have some relation to the RPI today, meaning that when you buy issues second hand, you look to get the relationship between the RPI at maturity and RPI today. On older issues that have a respectable coupon, the price is likely inflated over that implied by today's RPI.

It may be simpler to express everything in money terms. What do you pay today? What do you get in terms of annual income? What do you get at maturity? Having done that you then deflate the values to adjust for loss of purchasing power because of monetary inflation as measured by the RPI.

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Re: Understanding index linked gilts

#400634

Postby Midsmartin » March 31st, 2021, 5:25 pm

Since TG51 was only issued last month, I assume that it's intrinsic value (probably the wrong terminology) is barely over 100 ; 100 plus one month's rpi change, while I have to pay 184 to buy it.

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Re: Understanding index linked gilts

#400639

Postby Alaric » March 31st, 2021, 5:41 pm

Midsmartin wrote:Since TG51 was only issued last month, I assume that it's intrinsic value (probably the wrong terminology) is barely over 100 ; 100 plus one month's rpi change, while I have to pay 184 to buy it.


The maturity value in 2051 would be 100 * (Index in 2051) / (Index last month). If you have to pay 184 for it, that's the effect of negative real returns on pricing.

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Re: Understanding index linked gilts

#400654

Postby dealtn » March 31st, 2021, 6:13 pm

Midsmartin wrote:I'm trying to get my head around this; apologies for the basic question.
Can someone confirm if I'm doing this right please?

Let's take TG51 as an example. issued 8/02/21; maturity 22/03/51

Current price roughly 184

Am I correct in saying that if I want to have £10,000 in today's money repaid in 2051 when I'm in my 80s, I would have to buy approx £18400 of TG51 today? (ignoring interest, and the change in RPI over the last month).

As a thought experiment: even if RPI rose tenfold in the next 30 years the result is the same in real terms - £18k spent today would get me £10k in 2021 money on maturity (though in nominal terms it'll have another nought on the end).

Have I got this right?


Broadly, yes.

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Re: Understanding index linked gilts

#400657

Postby scrumpyjack » March 31st, 2021, 6:36 pm

As I understand it the market will price ILGs taking into account future expectations of inflation and interest rates on gilts that are not indexed linked. So as the market price of unindexed gilts guarantees a negative real rate of interest (based on market expectations of future inflation), the price of ILGs today will also guarantee a negative real return. On top of that, ILGs have tended to command a premium, AFAIW, because pension funds have to buy them to limit their future risks.

I haven't really kept up with ILGs (I did have a large holding many decades ago when you could get a guaranteed real return), but gather that often US government ILGs have offered better value. The potential fly in the ointment there, if in a taxable account, is that nominal gains on US ones are subject to CGT whilst gains on UK ones are not.

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Re: Understanding index linked gilts

#400662

Postby dealtn » March 31st, 2021, 6:54 pm

scrumpyjack wrote:As I understand it the market will price ILGs taking into account future expectations of inflation and interest rates on gilts that are not indexed linked. So as the market price of unindexed gilts guarantees a negative real rate of interest (based on market expectations of future inflation), the price of ILGs today will also guarantee a negative real return. On top of that, ILGs have tended to command a premium, AFAIW, because pension funds have to buy them to limit their future risks.



Sort of.

Unindexed Gilts don't guarantee a negative real rate of interest.

Unindexed, or Conventional, Gilts provide an interest return. That might be 0.5% at the moment say. If inflation is below 0.5%, negative even, they will deliver (assuming held to maturity) a real rate of return. If actual inflation is like the market implied inflation and is above the 0.5% then it will be negative real return.

Market implied inflation rates are determined by the implied prices, and yields, of the combination of Conventional and Index linked Gilts (termed "breakevens" in the market).

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Re: Understanding index linked gilts

#400670

Postby scrumpyjack » March 31st, 2021, 7:29 pm

dealtn wrote:
scrumpyjack wrote:As I understand it the market will price ILGs taking into account future expectations of inflation and interest rates on gilts that are not indexed linked. So as the market price of unindexed gilts guarantees a negative real rate of interest (based on market expectations of future inflation), the price of ILGs today will also guarantee a negative real return. On top of that, ILGs have tended to command a premium, AFAIW, because pension funds have to buy them to limit their future risks.



Sort of.

Unindexed Gilts don't guarantee a negative real rate of interest.

Unindexed, or Conventional, Gilts provide an interest return. That might be 0.5% at the moment say. If inflation is below 0.5%, negative even, they will deliver (assuming held to maturity) a real rate of return. If actual inflation is like the market implied inflation and is above the 0.5% then it will be negative real return.

Market implied inflation rates are determined by the implied prices, and yields, of the combination of Conventional and Index linked Gilts (termed "breakevens" in the market).


Yes I did say unindexed gilts guarantee a negative real return BASED ON MARKET EXPECTATIONS OF FUTURE INFLATION. ie if future inflation turns out to be in line with what the market currently expects, then a negative real return is certain.

Anyway however one 'verbalises the concept', as the US Ambassador once said, the meaning is the same :D

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Re: Understanding index linked gilts

#400694

Postby GoSeigen » March 31st, 2021, 10:14 pm

scrumpyjack wrote:Yes I did say unindexed gilts guarantee a negative real return BASED ON MARKET EXPECTATIONS OF FUTURE INFLATION. ie if future inflation turns out to be in line with what the market currently expects, then a negative real return is certain.

Anyway however one 'verbalises the concept', as the US Ambassador once said, the meaning is the same :D


One is verbalising the concept in a provocative and misleading manner. Not surprising there is push-back.

GS

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Re: Understanding index linked gilts

#401389

Postby 1nvest » April 3rd, 2021, 3:10 pm

scrumpyjack wrote:
dealtn wrote:
scrumpyjack wrote:As I understand it the market will price ILGs taking into account future expectations of inflation and interest rates on gilts that are not indexed linked. So as the market price of unindexed gilts guarantees a negative real rate of interest (based on market expectations of future inflation), the price of ILGs today will also guarantee a negative real return. On top of that, ILGs have tended to command a premium, AFAIW, because pension funds have to buy them to limit their future risks.



Sort of.

Unindexed Gilts don't guarantee a negative real rate of interest.

Unindexed, or Conventional, Gilts provide an interest return. That might be 0.5% at the moment say. If inflation is below 0.5%, negative even, they will deliver (assuming held to maturity) a real rate of return. If actual inflation is like the market implied inflation and is above the 0.5% then it will be negative real return.

Market implied inflation rates are determined by the implied prices, and yields, of the combination of Conventional and Index linked Gilts (termed "breakevens" in the market).


Yes I did say unindexed gilts guarantee a negative real return BASED ON MARKET EXPECTATIONS OF FUTURE INFLATION. ie if future inflation turns out to be in line with what the market currently expects, then a negative real return is certain.

Anyway however one 'verbalises the concept', as the US Ambassador once said, the meaning is the same :D

A ten year conventional gilt ladder yields 1.75% for 2021, for all prior years since at least 1938 saw 2%+ yields, so a historic low in that context. Can't see that 1.75% as being a guaranteed real loss however as 2021 inflation could very well be less than 1.75% and the gilt market is seemingly pricing to such low inflation expectation. I have used a strict ladder for that measure i.e. not marked to market (as each gilt is being held to maturity) so the rolling average of the prior ten 10 year gilt yields (in reality there are variations around that as not all rungs are loaded with equal capital weightings).

As part of a broader asset allocation it tends to wash. If I roll 2% of total portfolio value into a 10 year gilt each year, alongside spend a 2% SWR £ amount out of the total portfolio, then some rungs will be lighter/heavier than others as the portfolio value relatively fluctuates over time. The event that drove a relatively light loading into a ten year gilt i.e. portfolio relatively down at the time that one gilt matured and another 10 year was being added to the set using 2% of the then portfolio value, will more often see a reversal in that after a decade i.e. a bad ten years tends to be followed by a good ten years. If index linked gilts were being held for the rungs then when the maturity value is relatively light i.e. the portfolio was relatively down ten years ago when the gilt was bought, more often the growth/stock side will have made reasonable gains since then, such that the gap in income/spending can be filled by selling some shares. When a maturing rung is relatively heavy then there's some surplus available to add more stock shares that year.

Only in the singular case might you say that a current conventional gilts will lose in real terms and only IF the broader markets 10/whatever year prediction of 10/whatever year inflation proves to be accurate (or worse). No different to how Stock Options/Futures have forward collective predictions being made/priced-in. The actual precision/reliability of such predictions however are often proved wrong.

Guaranteed only in the singular and IF predictions are accurate, but where predictions often are wrong. More a case of a current collective best-guess, far from assured, no guarantee at all, anymore than predicting the FT100 is guaranteed lose money IF a prediction of a lower figure in x years/whatever time turns out to be accurate.

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Re: Understanding index linked gilts

#401424

Postby dealtn » April 3rd, 2021, 6:07 pm

1nvest wrote: Can't see that 1.75% as being a guaranteed real loss however as 2021 inflation could very well be less than 1.75% and the gilt market is seemingly pricing to such low inflation expectation.


Not sure you're correct on market inflation expectations. See the latest BoE Quarterly Report (page 26 Table 2.C a good reference should you prefer not to read it all - and consistent over the last few quarters too) with 1 year market implied inflation at 3.2%

https://www.bankofengland.co.uk/-/media ... y-2021.pdf

So whilst I agree this isn't guaranteed, I think you are too sanguine on your market implied claim.

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Re: Understanding index linked gilts

#401488

Postby 1nvest » April 3rd, 2021, 8:48 pm

Great link - thanks

Statista suggest (CPI) 2021 1.5%, 2022 1.8% https://www.statista.com/statistics/306 ... recast-uk/ BoE MPC does however feel like the better potential predictor

The way petrol, council tax (near 10% Greater London rate increase), energy ...etc. prices have recently jumped, I wouldn't be surprised to see more like the BoE MPC figure being the more inclined case.

Gold is down so a suggestion that real yields may move back to being positive and/or Pound strengthening (post Brexit decline rebound). Recent 20 year gilt price declines (yield increases) however still have them being priced to 1.3% type levels, so a pretty long term relativelylow interest rate (inflation) expectancy suggestion. Japan has struggled to induce inflation (negate deflation) for decades. Nobody really knows. Come July when a far deadlier mutation of Covid is out and about that is resilient to the vaccines and like the Spanish flu a century ago kills 30%+ of those contracting it - and 30% deflation levels could see current 20 year gilt prices being seen as having been bargains, and gold prices having trebled from present levels (stocks prices halved or more). Hopefully that isn't the case, but is a possibility.

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Re: Understanding index linked gilts

#401499

Postby 1nvest » April 3rd, 2021, 9:17 pm

Some opine inflation bonds such as index linked gilts to be 'safe'. But as ever with Gilts you're lending to someone who can adjust interest rates and taxation and set policies to steer inflation. Whilst they never want to be seen as having defaulted they can do so partially via stealth. 10% inflation, 10% inflation bond, 40% taxation ... -4% real type concept. At times when there is a low 'payout risk' such bonds might be plentiful, when the risk of payout increases so the market can dry up (new issues of National Savings inflation bonds being withdrawn since 2009 for instance).

One, if not the greatest of risks is concentration risk. 100% all-in into anything is a massive risk factor. A better 'inflation bond' involves a range of assets to avoid such concentration risk.

The concept of 'All Weather' type portfolios such as the Permanent Portfolio is to diversify/asset-allocate in a manner to better preserve capital over time rather than to potentially maximise rewards. 25% gold as 'insurance', 25% cash to carry income/spending through bad times, 25% stocks for growth/times-of-prosperity, 25% long dated gilts for times of deflation and that tend to move counter direction to stocks over the shorter term.

All-stock will tend to provide better rewards (maximise gains), but for some such high concentration and sequence of returns/withdrawals risks can backfire resulting in total loss.
Playing with the stock market is like playing chicken with a freight train... no matter how many times you win, you only get to lose once. -Mike Masters

All stock could see a decade of -4% annualised 'rewards', or worse. If you're also drawing a income and that scales up the 'compounding'. Where for some during the 1970's for instance their entire lifetime savings into stocks saw that lost across a relatively short period of time (less than a decade). And in a not so obvious type manner ... just happened and by the time it was realised it was too late.

Groucho Marx (Marx Brothers) was originally a stock investor, until he lost a fortune. Thereafter he never returned to stocks.

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Re: Understanding index linked gilts

#401537

Postby 1nvest » April 4th, 2021, 2:50 am

dealtn wrote:
1nvest wrote:I think you are too sanguine on your market implied claim.

China has kept their currency artificially low for years and have very tight rules about importing stuff whilst largely being free to export. Japan has had massive debt for decades. To address that the US, Euro, UK ..etc. are now doing likewise. BoE (BoJ ..etc.) in effect prints money to buy up whatever Gilts/Treasury's the treasury opts to issue ... and returns all interest paid on those gilts back to the treasury. Just a number. Conceptually the BoE could just tear up or return all of the gilts it holds back to the treasury and a large chunk of that debt would vanish at a pen-stroke/press-of-a-button. Many opine such policies will lead to inflation but it very often doesn't, just sustains further decline/depression. Perhaps such currency wars might end as per the Tripartite Agreement in 1936, where the majors all agree not to continue that 'game'. Even that however didn't help with the recovery of world trade.

For inflation, demand would have to outpace supply, which with technology efficiencies is unlikely to occur; And the demographics would have to turn, which it will ... eventually (decades away). As such deflationary pressures, currency wars, de-globalisation (currency controls etc.) type events are likely to be around for quite a while, as are low interest rates. Inflation may spike at times only to decline back down again.

Of all, the Euro is the more inclined to over-cook things. They've already printed enough to buy up all government debts, and then junk bonds, and may soon turn to buy up other assets such as stocks, homes ...etc. A grand nationalisation. Deflationary, where sooner or later people prefer tangible assets outside of the reach of the state whilst the state impose rules striving to prevent such. In US 1936 for instance it was made illegal to hold investment gold, all gold had to be sold to the state at the fixed rate ... or else. No one likes to be the loser, the scapegoat - so will go anything to avoid such, which elevates the risk of wars. As primarily no state is any safer than the strength of its military might rightfully the UK should increasing its debt by a trillion to chuck towards large scale expansion of its military capabilities (2 years mandatory national service etc.) and not focusing on cuts and austerity/taxation to 'pay down' a in effect lower debt cost nowadays compared to the £500Bn debt levels of 2007.


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