80% loss in 2 years on 'low risk' Index Linked Gilt

[CliffEdge]

In any case, it seems we are three years into a 50 year term. A lot can happen in that time.

Dod

Exactly. That's why they simply can't be described as low risk.

What risks apply to them specifically then, nuclear war etc applies to everything as a risk, my invisible dog for example, though I haven't seen him recently, I think I upset him when Fluffy slept in his bed one night.

Apparently, a physics student was explaining the other night, there is a possibility that the whole universe could suddenly disappear in an instant, small probability but not zero, I guess we'd never know if it did.

Interesting that.

[Lootman]

There are no risks during the holding period if you hold to maturity. If you do that you can totally ignore the vagaries of the market during its life and will still get exactly what you expected on the day you bought it.

I fully agree that they are not low risk if you don't hold to maturity, but that's not what I'm referring to.

But how sure can anyone be that a holder will be able to hold to maturity? I can probably come up with a scenario for any type of holder that might compel them to sell early, even if their original intention was to hold to maturity.

For example, an insurance company may encounter an excessive demand for cash, due to insured events increasing above that predicted. A pension fund can find its clients live much longer than actuaries thought, whilst the funds coming in decline beyond projection. A retail or institutional fund might suffer redemptions and withdrawals. A trust or foundation might be wound down. Or the assets are used as collateral for borrowings and there are margin calls. And so on.

As an aside I recall reading, when rates were declining to zero, that these institutions were being "forced" to buy these issues to meet requirements to match assets to liabilities. They knew they were buying dogs but had no choice. If so then logically by the same rules they may now be similarly forced to sell as rates go up.

Again, the government could massively devalue sterling and so the par value is repaid in near worthless confetti currency. Or the government could use a crisis to cram down changes to the implied contract. 50 years is a long time.

I guess the question I would ask is this: Would any of those buyers from 2 years ago, having lost 80% of their capital so quickly, reverse out that trade if they legally could? I would beg to suggest that they all would. All have buyer's remorse.

[Dod101]

The contributors here have more time than I have to argue about this. Presumably the gilt was issued with insurance companies and the like in mind, not the average retail investor. And so, the likely buyer would be deemed a professional and would understand what they were buying and why.

As such it is simply a waste of time and a pointless exercise for us to be discussing it. In any case, it seems we are three years into a 50 year term. A lot can happen in that time.

Dod

I'm glad my pension is not being managed by the 'professionals' who bought these ! (i.e. a guaranteed negative return of 2.5% each year for 50 years)

There is surely something we are (at least I am) not understanding. The index linked bit of the deal is presumably referring to the coupon and therefore the coupon is most likely to rise significantly over the 50 year period. To judge an outcome of a 50 year gilt over 2 or 3 years seems to me to be pointless but I agree that a 'real' return of negative 2.5% p a over a 50 year period does not seem a good deal but is there more to it than that?

Dod

[SalvorHardin]

.As an aside I recall reading, when rates were declining to zero, that these institutions were being "forced" to buy these issues to meet requirements to match assets to liabilities. They knew they were buying dogs but had no choice. If so then logically by the same rules they may now be similarly forced to sell as rates go up.

Yes, that's what happened. Asset-Liability matching gone mad. Forced matching of long-term liabilities by using gilts instead of equities is consequence of the 1995 Pensions Act and its successors.

I haven't worked in the field for over twenty years, but I remember that the Minimum Funding Requirement (MFR) in the 1995 Pensions Act created a positive feedback loop. By specifying minimum levels of gilt investment, the demand for gilts rose pushing down yields. The fall in gilt yields meant that the MFR gererally required funds to buy even more gilts and sell equities. This was changed somewhat with the 2004 Pensions Act.

I wouldn't be in the least bit surprised if the negative yield on this gilt was acceptable because of some weird interaction of the statutory funding rules screwing around with asset-liability models. This sort of box-ticking is how we got people buying a guaranteed -2.5% real return over 50 years (real loss of 71.8%).

[scrumpyjack]

.As an aside I recall reading, when rates were declining to zero, that these institutions were being "forced" to buy these issues to meet requirements to match assets to liabilities. They knew they were buying dogs but had no choice. If so then logically by the same rules they may now be similarly forced to sell as rates go up.

Yes, that's what happened. Asset-Liability matching gone mad. Forced matching of long-term liabilities by using gilts instead of equities is consequence of the 1995 Pensions Act and its successors.

I haven't worked in the field for over twenty years, but I remember that the Minimum Funding Requirement (MFR) in the 1995 Pensions Act created a positive feedback loop. By specifying minimum levels of gilt investment, the demand for gilts rose pushing down yields. The fall in gilt yields meant that the MFR gererally required funds to buy even more gilts and sell equities. This was changed somewhat with the 2004 Pensions Act.

I wouldn't be in the least bit surprised if the negative yield on this gilt was acceptable because of some weird interaction of the statutory funding rules screwing around with asset-liability models. This sort of box-ticking is how we got people buying a guaranteed -2.5% real return over 50 years (real loss of 71.8%).

Perhaps it is a really clever plan by the blob to force pension funds to pay off the national debt, because that is what in reality this is doing, and then they complain about pension funds being under funded!

[GoSeigen]

….Oh and BTW at issue the market price is the yield obtainable at the chosen par value…

The market price is in ‘£’s’, and the yield is in ‘%/yr’. How can one be the other? It seems akin to saying ‘distance is speed’.

Distance is speed (quoting) if you define your journey as taking a fixed time, eg. 100s (in the same way that par value is fixed at 100p -- the coupon follows from the yield).


GS

[GoSeigen]

Demand for gilts doesn't push down yields. At a minimum it's a balancing act of supply and demand but actually its not even that, supply and demand is a poor concept to apply to securities trading.


But I know it's fashionable to blame gilts prices on that law, interesting how that particular law also caused demand for JGBs, treasuries and Euro bonds and pushed their yields down but hey, what do I know?

GS

[mc2fool]

There are no risks during the holding period if you hold to maturity. If you do that you can totally ignore the vagaries of the market during its life and will still get exactly what you expected on the day you bought it.

I fully agree that they are not low risk if you don't hold to maturity, but that's not what I'm referring to.

But how sure can anyone be that a holder will be able to hold to maturity? I can probably come up with a scenario for any type of holder that might compel them to sell early, even if their original intention was to hold to maturity.

Yeah, but that too is exogenous, not a risk of the gilt per se. Of course there are external risks, like, as already mentioned, you might die, there might be nuclear war, aliens might invade etc etc, but those apply to everything, even life itself.

Again, the government could massively devalue sterling and so the par value is repaid in near worthless confetti currency. Or the government could use a crisis to cram down changes to the implied contract. 50 years is a long time.

The gilt in discussion is an index-linker and as a massive devaluation would most likely be accompanied by massive inflation the par value would be likely to be maintained. Yes, the government could breach the contract but for the UK that's pretty unlikely to happen (and is why I said in my OP that if holding to maturity it would be almost zero risk).

I guess the question I would ask is this: Would any of those buyers from 2 years ago, having lost 80% of their capital so quickly, reverse out that trade if they legally could? I would beg to suggest that they all would. All have buyer's remorse.

Beh, you could ask the same of shareholders in Carillion, RBS, etc, depositors in BCCI, Lehmans, etc, clients of Equitable Life, etc etc. I don't see that such retrospective crystal ball gazing is particularly useful. And I don't think you can speak for "all" buyers; I wouldn't be surprised if there are some actuarial accountants that, having bought it, simply put it into a file marked "open in 2073".

Of course, as to why they bought it in the first place, that's been covered and I can't imagine that there were (m)any private investors that figured locking in a -2.5%pa real return for 50 years was a stonking idea!

[mc2fool]

I'm glad my pension is not being managed by the 'professionals' who bought these ! (i.e. a guaranteed negative return of 2.5% each year for 50 years)

There is surely something we are (at least I am) not understanding. The index linked bit of the deal is presumably referring to the coupon and therefore the coupon is most likely to rise significantly over the 50 year period. To judge an outcome of a 50 year gilt over 2 or 3 years seems to me to be pointless but I agree that a 'real' return of negative 2.5% p a over a 50 year period does not seem a good deal but is there more to it than that?

Both the coupon and the par value get indexed by RPI* but it's still a real -2.5%pa. As I say above, I can't imagine there were (m)any private investors that went for it...!

* Until 2030 after which they'll still be indexed by RPI but the RPI methodology will change then to be the same as CPIH.

[GeoffF100]

I'm glad my pension is not being managed by the 'professionals' who bought these ! (i.e. a guaranteed negative return of 2.5% each year for 50 years)

There were plenty of people who bought index linked annuities. Given sufficient money, they secured a guaranteed income for life that would give them a comfortable retirement. If they had waited a year or so they could have got a significantly higher retirement income. They could not have known that. The markets did not predict it, and neither did the central banks. It was not a "risk". They did the prudent thing. With hindsight, there will always be better investments. If I knew the future, I would be a billionaire in no time.

[Lootman]

I'm glad my pension is not being managed by the 'professionals' who bought these ! (i.e. a guaranteed negative return of 2.5% each year for 50 years)

There were plenty of people who bought index linked annuities. Given sufficient money, they secured a guaranteed income for life that would give them a comfortable retirement. If they had waited a year or so they could have got a significantly higher retirement income. They could not have known that. The markets did not predict it, and neither did the central banks. It was not a "risk". They did the prudent thing. With hindsight, there will always be better investments. If I knew the future, I would be a billionaire in no time.

The word "risk" usually means an informed assessment of the probability of losing money. In this case the buyers of this issue knew for a fact that they were going to lose a lot of money and so the normal concept of risk doesn't apply, which seems to be your point.

What the buyers of these issues did not know was that a large amount of that inevitable loss would come over 2 years rather than 50. I doubt that they anticipated that. And I doubt that many of them are now thinking "Oh, everything is OK because I never intended to sell before maturity anyway". If nothing else the possibility of profitably selling these things on to a greater fool has vapourised. As an old saying has it: "A long-term holding is a short-term holding that went wrong".

[scrumpyjack]

I bought index linked gilts in the '80s, when they gave a positive real return and provided an excellent protection against the reliable prospect that governments would debase the currency via inflation, but I didn't buy anything longer than 10 years. It worked out well, but to buy a 50 year one knowing it will lose real value at 2.5% per annum (over 70% of its value over the term), utterly bananas unless forced to by legislation.

[NotSure]

I bought index linked gilts in the '80s, when they gave a positive real return and provided an excellent protection against the reliable prospect that governments would debase the currency via inflation, but I didn't buy anything longer than 10 years. It worked out well, but to buy a 50 year one knowing it will lose real value at 2.5% per annum (over 70% of its value over the term), utterly bananas unless forced to by legislation.

I'd have said the same at e.g. -1% real, but anyone who bought then had the opportunity to sell for a decent profit later. I'm not sure who buys long duration bond for their yields - aren't they more a "leveraged" punt on the future of interest rates? Duration risk (for me) is duration opportunity for braver types?

[dealtn]

Well I am sorry if I am not making myself clear but even IF held to maturity there are both a lot of risks on that timeline, and even on arrival you might not get what you expect. If that risk can't be seen perhaps consider what could happen IF

The definition of inflation changes over that 50 years.

The rules on CGT change

A wealth tax is introduced

Redemption rules of the issuer change limiting the amount that can be repaid.

Bear in mind the issuer is the primary legislator in the country, and will remain so over the life of the investment

...

That's before considering those risks you seem to want to ignore during the holding period which are even greater.

Generally the terms 'risk-free' and 'zero risk', as applied to US and UK government debt, specifically refer to default risk. Other risks (which are numerous as you suggest) have nothing to do with the 'risk free' term.

Those terms aren't typically used in those markets either - but even if they were that's irrelevant, they weren't used here! The words were low-risk. There is a risk, and its not what I would consider to be low having worked in those markets for nearly a quarter of a century - mostly in benign or positive environments for Fixed Income too!

[dealtn]

Well I am sorry if I am not making myself clear but even IF held to maturity there are both a lot of risks on that timeline, and even on arrival you might not get what you expect. If that risk can't be seen perhaps consider what could happen IF

The definition of inflation changes over that 50 years.

The rules on CGT change

A wealth tax is introduced

Redemption rules of the issuer change limiting the amount that can be repaid.

Bear in mind the issuer is the primary legislator in the country, and will remain so over the life of the investment

...

That's before considering those risks you seem to want to ignore during the holding period which are even greater.

The definition of inflation will change (in 2030) and that's already known and was so from issuance, and if it changes again it is very unlikely to affect any gilt already in issue (as it didn't with the 2030 change when it was announced). Similarly the chances of the government simply changing the redemption amount is pretty near zero. The whole point of gilts is that they are a contract that offers a totally known quantity to maturity.

Taxes are exogenous changes that don't affect the security itself. If you want you could add to your list the "risk" that the investor goes from being a BRT to an HRT thereby reducing their net return from the coupon, but I don't consider that a risk of the gilt.

There are no risks during the holding period if you hold to maturity. If you do that you can totally ignore the vagaries of the market during its life and will still get exactly what you expected on the day you bought it.

I fully agree that they are not low risk if you don't hold to maturity, but that's not what I'm referring to.

We will have to disagree. I worked for nearly 25 years in the City and was involved in 2 of the 3 inflation consultations undertaken in that period by government agencies. There were (and remain) large risks on inflation definition and change of terms. Without getting overly technical the CPI/RPI basis is not constant at 0.5% and there is a term structure to that basis market too. Its far from impossible a new index is introduced in the 50 year period concerned here. Try telling anyone in the risk free Libor market that their 50 year contract wasn't affected by the radical change (and almost literal disappearance as a result) of Libor in the last few years.

At some point over the next 50 years we could have consolidation of euro denominated government debt such that all legacy countries are standardised. We could see the UK and GBP enter later in that period too. We could see consolidation of date from gbp to euro denominated, and acceptance of terms of euro CPI or different as part of that. Where might investors sit in the credit spectrum from Germany to Greece? We don't know - the europeans don't yet either. You won't know the terms of entry let alone maturity should it happen.

Tax effects can easily be different across different investment entities, and even have the different impacts on the same asset classes. Consider a 1% wealth tax which could easily be adopted based on the "current value" not par redemption. A long duration Gilt whose price could vary from 50 to 250 subject to 1% deduction could see periods of annual "cost" greater than 2% of nominal. That wouldn't be as extreme for cash or short dated gilts over the same 50 year period. Consider the compounding running annual difference.

You could have inflation contracts redefined to align with the increasingly normal LDI market where only the range 0-5% is all that matters. Try the argument that RPI and LDI swaps and hedging are broadly equivalent now - quite fashionable only a few years ago - now we have witnessed double digit RPI (and CPI). The 50 year difference in payout can be hugely different.

I could go on. These aren't even especially Black Swan events, all have been talked about and discussed by academics and the market, They might not be high risk, they might not be probable (but will have big consequences if introduced). Describing holding an investment for 50 years as low risk when there are events over that time frame that can have considerable compounding impacts on the owner over both that time AND on maturity is simply wrong.

[1nvest]

They're not low risk, they're (almost*) zero risk. Those that bought at around £330 knew that if held to maturity they'd be getting a negative (real) yield of 2.5pc, and that hasn't and won't change.

* there is always, of course, the risk of the govt defaulting....

50 years of -2.5% real = 28% of your inflation adjusted initial investment return. A case of the law (state/issuer) insisting that pension funds hold them, a.k.a a indirect taxation of peoples pensions.

[hiriskpaul]

They're not low risk, they're (almost*) zero risk. Those that bought at around £330 knew that if held to maturity they'd be getting a negative (real) yield of 2.5pc, and that hasn't and won't change.

* there is always, of course, the risk of the govt defaulting....

50 years of -2.5% real = 28% of your inflation adjusted initial investment return. A case of the law (state/issuer) insisting that pension funds hold them, a.k.a a indirect taxation of peoples pensions.

AFAIK there is no law that states a pension fund must invest in gilts, indexed or non-indexed. It is more a case of pension fund rules being such that indexed linked gilts lend themselves to liability driven investment strategies. Why so many fund managers and/or their regulators, failed to take a step back once ultra long duration gilts got to insanely negative real yields is a bit of a mystery. Hopefully there is an ongoing stable door closing investigation that might at some point clear it up.

[1nvest]

50 years of -2.5% real = 28% of your inflation adjusted initial investment return. A case of the law (state/issuer) insisting that pension funds hold them, a.k.a a indirect taxation of peoples pensions.

AFAIK there is no law that states a pension fund must invest in gilts, indexed or non-indexed. It is more a case of pension fund rules being such that indexed linked gilts lend themselves to liability driven investment strategies. Why so many fund managers and/or their regulators, failed to take a step back once ultra long duration gilts got to insanely negative real yields is a bit of a mystery. Hopefully there is an ongoing stable door closing investigation that might at some point clear it up.

Yes, pension funds under regulation rules have a "duty to act prudently" and are required to consider "the suitability of different asset classes to meet the needs of the scheme and future liabilities". Most pension funds hold 50%+ in Gilts as part of fulfilling that regulatory obligation, or otherwise risk being considered outside of having been prudent or not having liability matched.

[DrFfybes]

I notice today the Torygraph points out the incredible loss on an ILG issued less than 2 years ago.

"But how about this for an asset price crash: when issued less than two years ago, the March 2073 Index-Linked Gilt was priced at around £330 per unit of stock; the current price is just £62, or less than a fifth of its value when initially sold.

The effect has been to transform a negative yield of 2.5pc into a positive one of 1.13pc."

I've been trying to get my head around this for a day or 2, but I'm not sure I'm entirely clued up on how this works, so please bear with me and correct me if I'm wrong.

The PAR value is £100, so why such a high initial high price - was it oversubscribed?
At maturity date - 50 years away, the redemption value will be £100 multiplied by the inflation index used over that period?
Every year it yields 12.5p interest for each bond held (0.125% of the Par value).

Currently they're £62 or so, so over the next 50 years the annual return will be roughly 1.5 x RPI (+ the nominal interest), as the RPI increase applies to the £100 Par value? ie - if inflation is 3% for the next 50 years the actual return if bought today would be nearer 4.5%?

thanks

Paul

[mc2fool]

I've been trying to get my head around this for a day or 2, but I'm not sure I'm entirely clued up on how this works, so please bear with me and correct me if I'm wrong.

The PAR value is £100, so why such a high initial high price - was it oversubscribed?
At maturity date - 50 years away, the redemption value will be £100 multiplied by the inflation index used over that period?
Every year it yields 12.5p interest for each bond held (0.125% of the Par value).

Dunno.
Yes, at maturity the redemption value will be £100 multiplied by the increase in the inflation index since issuance.
The coupon is also indexed, i.e. each year it yields 0.125% of the then indexed par value.

Currently they're £62 or so, so over the next 50 years the annual return will be roughly 1.5 x RPI (+ the nominal interest), as the RPI increase applies to the £100 Par value? ie - if inflation is 3% for the next 50 years the actual return if bought today would be nearer 4.5%?

The current unindexed price is around £62. Indexation applies/will apply to both the current price and redemption amount, so if you buy today then in 50 years time you'll be able to buy 100/62 = 1.613 times more gobstoppers than you could today, irrespective of the level of inflation (assuming gobstopper inflation is the same as the increase in the indexation ).

For yields it's best to think in real terms and you can use the unindexed values to get the real (post inflation) gross redemption yield.

=YIELD(TODAY(),"22-Mar-2073",0.125%,62,100,2,3) gives 1.13%

https://www.yieldgimp.com/index-linked-gilt-yields says that the current indexation ratio is 1.21794, so the indexed price is currently ~£62 * 1.21794 = ~£75.51, and the current coupon 12.5p * 1.21794 = 15.22p.