I don't get it with Index Linkers

[indicator]

I don't think there's anything mysterious here. The OP bought a few tranches of an index-linker ETF (he/she omitted the word ETF but helpfully included the EPIC (Link removed for posting) He/she has found that the price of the EFT has fallen, obviously because the price of the underlying has fallen.

Index linked bonds protect you from the effects of inflation, that is not in dispute. However you have no protection from rising yields (either real or nominal), why would you? As was widely discussed on these boards, gilts have been ridiculously priced for some years, real yields of many shorter dated linkers were negative(!!) and even longer-dated linkers had yields never seen in the history of UK debt.

So it's no surprise prices have fallen sharply as people realise that 0% is not an acceptable yield for a long-term fixed interest product.


GS

Good explanation but I am still not convinced the OP understood what she was buying, which is an important point, it being one thing to buy a bond but another thing to buy a fund of bonds - though the outcomes might be correlated, possibly.

I don't think there's a material distinction in this case. The EFT will perform in line with the underlying.

GS

But the ETF will not have a maturity date so the return is not locked in, whereas it is for a bond held to maturity, or maybe a bond ladder. Anyway the OP has not responded so still not really sure what her question meant.

As the OP here I am still trying to understand the mistake that I seem to have made in buying the ETF. In simplistic terms I hoped to protect my savings from inflation and I admit that I did not take into account the impact of rising yields (even though they seem to be tiny compared with the high rate of infation). So now I have to make a decision whether to sell and take the loss or hold on and lose more as it seems that yields have not peaked.I also admit to tinkering in something that I did not fully understand so thank you all for the help. What would you do in these circumstances?

[GoSeigen]

As the OP here I am still trying to understand the mistake that I seem to have made in buying the ETF. In simplistic terms I hoped to protect my savings from inflation and I admit that I did not take into account the impact of rising yields (even though they seem to be tiny compared with the high rate of infation). So now I have to make a decision whether to sell and take the loss or hold on and lose more as it seems that yields have not peaked.I also admit to tinkering in something that I did not fully understand so thank you all for the help. What would you do in these circumstances?

IMV not too much is lost. If you look around a lot of the assets you may have bought instead of gilts have also fallen in price (quite likely for the same reason -- rising yields/discount rates). So you could take a view that the inflation scenario has happened, you'll take your inflation protection and swallow the yield loss, and buy some of the other stuff that has fallen.

Alternatively you could say that yields have corrected now, but your hunch about rising inflation was clearly correct and as inflation might well continue you still want the inflation protected bonds. The problem with this view is that you have been shown to have overlooked the yield aspect of gilts and you'll need to question whether current yields represent a reasonable return if your inflation scenario continues over a longer period, and also what the effect on your gilt prices will be if further yield falls occur. (Hint: INXG duration is still 18 years, so you lose 18% of capital for every 100bp of gilt yield rise).

You could also say that purely as a matter of asset allocation it's never bad to have a few bonds, but part and parcel of that is sometimes they will fall in price. You could consider rebalancing by buying a few more if they get underweight.

Whatever you do, make sure you are comfortable with the rationale and remember it if things go wrong again and reassess.

I can't tell you what view to take but personally, I don't hold gilts, though I was a big holder for a long time up to 2016/17 or so. I'm tempted to buy a few vanilla gilts at the short/medium end but will probably delay the purchase for a bit because I'm conscious that psychologically I tend towards buying too early. My portfolio is currently roughly 100% equities and corporate fixed interest.

As a matter of general investing strategy I'd say it's not a good idea to double up if your initial ideas have not worked out. You need a sound reason to add in that circumstance; one good reason for example might be that your initial tranche was deliberately small and you wish to add to get closer to your target allocation.

Good luck.

GS

[CliffEdge]

Good explanation but I am still not convinced the OP understood what she was buying, which is an important point, it being one thing to buy a bond but another thing to buy a fund of bonds - though the outcomes might be correlated, possibly.

I don't think there's a material distinction in this case. The EFT will perform in line with the underlying.

GS

But the ETF will not have a maturity date so the return is not locked in, whereas it is for a bond held to maturity, or maybe a bond ladder. Anyway the OP has not responded so still not really sure what her question meant.

I don't understand what you mean by the return being "locked in" for an investment of almost 20 years duration whose value we are discussing one year after having purchased it?

GS

I'm not claiming the return is locked in for the ETF. I'm sorry if I didn't make that clear enough though I feel I tried. The return is locked in for bonds held to maturity and you can choose a bond with one year to maturity, or two years to maturity, or yes twenty years to maturity.
Or pretty much whatever you like but I agree that the OP didn't buy bonds so maybe my comments are off topic though I wasn't sure of that in the first place and I also thought that highlighting the difference between a bond fund and a bond might be useful for the OP and others in her position.
Somewhere on here I've seen a really good explanation of the difference and its implications by one of the experts. If I can find it I'll post a link.

[GoSeigen]

I'm not claiming the return is locked in for the ETF. I'm sorry if I didn't make that clear enough though I feel I tried. The return is locked in for bonds held to maturity and you can choose a bond with one year to maturity, or two years to maturity, or yes twenty years to maturity.

True but completely irrelevant to the discussion which is not about holding to maturity, that's all I'm saying...

GS

[CliffEdge]

I'm not claiming the return is locked in for the ETF. I'm sorry if I didn't make that clear enough though I feel I tried. The return is locked in for bonds held to maturity and you can choose a bond with one year to maturity, or two years to maturity, or yes twenty years to maturity.

True but completely irrelevant to the discussion which is not about holding to maturity, that's all I'm saying...

GS

Not completely irrelevant but I take your point, not directly relevant.

[tjh290633]

I'm not claiming the return is locked in for the ETF. I'm sorry if I didn't make that clear enough though I feel I tried. The return is locked in for bonds held to maturity and you can choose a bond with one year to maturity, or two years to maturity, or yes twenty years to maturity.

True but completely irrelevant to the discussion which is not about holding to maturity, that's all I'm saying...

GS

Is not the real point that a fund is unlikely ever to hold a security to maturity, but willl switch to later maturities as time passes?

As there is a wide range of maturities, the whole thing becomes increasingly obscure.

TJH

[Alaric]

Is not the real point that a fund is unlikely ever to hold a security to maturity, but willl switch to later maturities as time passes?

An ETF in particular is likely to have an underlying market index which it will track. It's in the nature of indexes that they are constructed so that the average outstanding duration stays more or less the same as time passes, thus to follow the index implies churning.

Another way of looking at it would be to observe that if you purchased an individual index linked stock and held it to maturity, you would eventually see the return implicit in the underlying price index used to revalue it. There's a caveat though, it isn't going to work unless the real rate of return when purchased was positive. That's something that's not been the case for some years.

[JohnW]

Your bond fund is holding many different bonds acquired over some years as they’ve been issued by the treasury, all at times when interest rates were lower. Now that interest rates have risen, people, or funds, can buy bonds like yours (but new ones), and the new ones will be paying more. So of course yours have dropped in value, to the extent that anyone buying them today would get the same yield as that person buying the new higher paying bonds. Over time your fund’s bonds will mature to be replaced by new higher paying bonds. So, the worst time to sell your fund would be just after interest rates have risen and pushed your fund value down, and before the fund has had the chance to replace the old lower paying bonds with new higher paying ones, which fund holders will increasingly benefit from as time goes by.
A bond fund like yours is not a short term investment, rather it’s medium to longer term. So, as long as you’re a medium to longer term investor and not a short term one, then it can be a good choice for you; and you certainly wouldn’t invest in it short term (by selling soon after buying) if you’re not a short term investor. That’s the second reason not to sell now.
For longer term investing, the best results are likely to come from choosing a suitable portfolio and hanging on to it for the long term; that way it can reach its potential which it can’t if you're chopping and changing it. Endless research (Dalbar does it) shows that the average fund investor gets worse returns than the funds they invest in because they make poor buy and sell decisions often jumping in during market exuberance and bailing out during big falls. That’s the third reason not to sell now.
To make good decisions about investments that suit your circumstances one needs to have a bit of an understanding about the assets you invest in (not hard), portfolio ‘construction’ is the jargon (not hard), and behavioural challenges that can trip you up (bit harder). You owe it to yourself to look into these matters before you make any more investment decisions, and it probably involves a bit more active learning than posting to an internet forum. 
That’ll take a bit of time and it’s the fourth reason not to sell yet. Good luck.

[CliffEdge]

There's a caveat though, it isn't going to work unless the real rate of return when purchased was positive. That's something that's not been the case for some years.

Not necessarily, I may be willing to lose say 1% a year over the next five years to maturity if I fear 10% inflation pa is going to stick over that period. In five years time I would have 95% of my original capital instead of 66% if I left it in my current account. I might consider the 1% cost per year as a worthwhile paying capital insurance fee.

[indicator]

Your bond fund is holding many different bonds acquired over some years as they’ve been issued by the treasury, all at times when interest rates were lower. Now that interest rates have risen, people, or funds, can buy bonds like yours (but new ones), and the new ones will be paying more. So of course yours have dropped in value, to the extent that anyone buying them today would get the same yield as that person buying the new higher paying bonds. Over time your fund’s bonds will mature to be replaced by new higher paying bonds. So, the worst time to sell your fund would be just after interest rates have risen and pushed your fund value down, and before the fund has had the chance to replace the old lower paying bonds with new higher paying ones, which fund holders will increasingly benefit from as time goes by.
A bond fund like yours is not a short term investment, rather it’s medium to longer term. So, as long as you’re a medium to longer term investor and not a short term one, then it can be a good choice for you; and you certainly wouldn’t invest in it short term (by selling soon after buying) if you’re not a short term investor. That’s the second reason not to sell now.
For longer term investing, the best results are likely to come from choosing a suitable portfolio and hanging on to it for the long term; that way it can reach its potential which it can’t if you're chopping and changing it. Endless research (Dalbar does it) shows that the average fund investor gets worse returns than the funds they invest in because they make poor buy and sell decisions often jumping in during market exuberance and bailing out during big falls. That’s the third reason not to sell now.
To make good decisions about investments that suit your circumstances one needs to have a bit of an understanding about the assets you invest in (not hard), portfolio ‘construction’ is the jargon (not hard), and behavioural challenges that can trip you up (bit harder). You owe it to yourself to look into these matters before you make any more investment decisions, and it probably involves a bit more active learning than posting to an internet forum. 
That’ll take a bit of time and it’s the fourth reason not to sell yet. Good luck.

Thank you for your concern and wise words JohnW.I can confirm that I am a LTBH investor,60% in FTSE equities,40% in cash ( it was until I simplistically bought the Index Linked ETF with most of the cash) and no foreign holdings. The failure to "do my own research" in this case has left me in a quandary. I now take the point about yields versus inflation but that is just the base of my learning curve it seems. As this is an ETF with no redemtion yield (for me) I need to calculate the likelihood of a larger loss than presently being experienced. Looking at present forecasts of inflation peaking at 11% within this year and the BoE raising interest rates to,say 2.75%, is there a calculation that can be made to roughly determine the value of an ETF IL bond within that year or two? The only mention I have been able to find is to calculate the annual growth (yield?) and subtract the rate of inflation. Should this be correct,then in my view of the UK economy I shall be sitting on a heavy paper loss over the next few years.

[JohnW]

The duration of your bond fund is 18 years; that’s an important characteristic for bond investing because it’s the weighted (by £) average of all the future periods that a bond pays out until redemption at maturity. So if most of the money comes to you at maturity as principal, because interest rates are very low and thus coupon payments are very small, then the duration will be similar (but shorter) than the ‘time to maturity’. Keep 18 years in mind for your circumstances (which you haven’t told us).
A rough and ready use of duration is to inform you how much your bond(s)/fund will drop in price with an interest rate rise. x% rise in interest rates will drop the bond’s value by x% times the duration in years. Your fund should fall 18% for each 1% rise in interest rates - very, very roughly, and not for long.
We’ll come back to that, but before you slit your throat at the prospects of further rate rises, just reflect on how good your portfolio is at present. A 60/40 equity/bond mix, yours, is widely considered very suitable for many investors; we don’t know enough about you to pontificate, but it’s not a bad setup for anyone with a good few years to go. Secondly, what sort of bonds should be in the 40%? There are good reasons to think yours are perfect (however unfortunate the timing of purchase was). High quality bonds have poor returns compared to riskier assets; you just have to accept it if you’re going to hold bonds (and most investors probably should). The risks of bonds are: #1 credit risk (you’ve got that covered with UK treasury as the issuer); #2 interest rate risk (the longer the duration, the more the risk as per the formula above, but also the better the yield usually). The only protection against this is short duration, lower paying bonds); and #3 unexpected inflation (you’ve got that covered as well as anyone can with linkers in the currency you spend, although you’ve added the risk that would come with unexpected deflation).
As long as your investing horizon is long enough to suit 18 year duration bonds, you’ve got a bond holding as good as anyone’s. Some would argue that having only linkers does not give you the protection against deflation that nominal bonds do, but inflation is much more common than deflation, and usually more damaging to your spending capacity. You won’t find many people holding only linkers as their bonds, but the logic of their argument is often not there and the size of the effect they’re worried about likely small. Hopefully we’ll hear some discussion on this.
So, I contend, the only ‘worry’ you have is does the 18 years match your investing horizon? At age 60 it probably still does if you’re planning to live off an ‘at risk’ portfolio of stocks and bonds; beyond 60 years, maybe an 18 year duration bond fund is too long, so what’s a solution?
It’s a truth universally acknowledged that a bond holding should duration match the spending horizon of the bond holder. If your spending needs are a long way off, you should have long bonds since they pay better; but since it exposes you to interest rate risk, no longer than your spending needs. You can roughly calculate your spending ‘duration’ as the average of those future spending years eg if you only need to spend for the next 5 years, the duration is (1+2+3..5)/5=3years. If your spending starts in 6 years and runs for 10 years, the duration is (1+2+3…10)/10 add 6=11.5 years.
Since a bond fund’s duration usually stays unchanged, but your spending duration naturally keeps getting shorter, in order to ‘duration match’ your bonds with your spending you might need/want another (bond) fund (could be cash) which when ‘mixed’ with your long (18 year) bond fund in their relative proportions gives a combined duration that matches your spending horizon. Here you can read about it: https://www.bogleheads.org/forum/viewtopic.php?t=318412
Finally, we come back to your 18% drop for every 1% rise in interest rates. How dramatic that fall is, whether it’s actually 12% not 18%, how quickly or slowly the fund recovers its value as the new higher paying bonds come on line varies with the prevailing economic circumstances. Have a look at this bond fund rising inexorably through rising and falling interest rate periods, where the ’18%’ formula just doesn’t seem apparent. https://www.bogleheads.org/forum/viewto ... 2#p5846789
And look at this theoretical analysis showing how your bond fund can recover, hopefully giving you some comfort. https://www.bogleheads.org/forum/viewtopic.php?t=360575
You might have stumbled on a genius portfolio, but make the next move well informed.

is there a calculation that can be made to roughly determine the value of an ETF IL bond within that year or two?

I don’t think you can do that, as it relies on predictions, and here’s what we know about those: https://www.marketwatch.com/story/yes-1 ... 2014-10-21

[GoSeigen]

Excellent post by JohnW which merits a bit of study if the meaning is not immediately clear.


GS

[indicator]

Crikey,JohnW.What a wonderful piece of work and so well explained.You have taken me up the learning curve by a point or two,but there is so much in front of me yet to be revealed. I am now going to go away from this discussion to consider your words and begin some additional and greatly needed research.
So,once again,thank you for the time and knowledge that you have offered and the links supplied to get me underway. Also thanks to GoSeigen for your supportive and helpful posts. What a great discussion board this is.

[james51]

This is an excellent discussion. It has been explained the pricing of INXG but what is now baffling me is what is happening to the distributions.

I hold both INXG and individual Index Linked Gilts. On my individual Gilts, the 6 monthly coupon is increasing in line with inflation and arriving in my bank account bang on time, but with INXG, not only were the distributions falling, but for the last 18 months they have been Zero. What is INXG doing with the cash being paid out by the underlying holding?

[GoSeigen]

This is an excellent discussion. It has been explained the pricing of INXG but what is now baffling me is what is happening to the distributions.

I hold both INXG and individual Index Linked Gilts. On my individual Gilts, the 6 monthly coupon is increasing in line with inflation and arriving in my bank account bang on time, but with INXG, not only were the distributions falling, but for the last 18 months they have been Zero. What is INXG doing with the cash being paid out by the underlying holding?

No dividend was declared by the directors, presumably because the income from the gilts held by the fund did not cover the fees and expenses. e.g. https://www.londonstockexchange.com/news-article/INXG/dividend-declaration/15199299

Refer to the iShares II prospectus for further info.

GS

[Alaric]

What is INXG doing with the cash being paid out by the underlying holding?

Putting it in their back pocket as charges. More recent issues of indexed Gilts have minimal coupons, seemingly not even enough to leave a positive balance after charges.

[Alaric]

Not necessarily, I may be willing to lose say 1% a year over the next five years to maturity if I fear 10% inflation pa is going to stick over that period. In five years time I would have 95% of my original capital instead of 66% if I left it in my current account. I might consider the 1% cost per year as a worthwhile paying capital insurance fee.

You wonder perhaps if there's room for a retail bond which does something like that. There's no annual interest, but at the end of the period, the return is a percentage of movement in a Price Index. Perhaps no one could make it work, or if they could, the FCA thought it "too complicated "for the retail market. At negative real yields, the return percentage might seem too low to make it worth marketing.

[dealtn]

#3 unexpected inflation (you’ve got that covered as well as anyone can with linkers in the currency you spend, although you’ve added the risk that would come with unexpected deflation).

Don't forget though that it is price that matters here too. Owning linkers doesn't guarantee your capital's value against the effects of inflation, it only locks in the real loss or gain.

Buy linkers at a price of 200 and you are protecting your capital to the extent it will only half in real terms when it is paid back at par of 100. So you have captured the inflation risk, but crucially that is very different to inflation protecting your capital. The clue is the word "link" in the name of the bond and not something like "protection" or "preservation".

[JohnW]

Indeed that is a valid consideration. I alluded to it when I wrote that the timing of the purchase was somewhat unfortunate, and that safe bonds have low returns compared to riskier assets; but it's good to elaborate and spell it out as you have.
Recently the yields on linkers was slightly negative for long and short bonds, about zero to minus 1%/year, and currently have just become positive for some of the longer ones: https://www.bankofengland.co.uk/statistics/yield-curves. I hope I'm reading those curves correctly. So that if interest rates didn't change for the next 20 years your linkers bond fund would protect you against any rises in the retail consumer price index but it would guarantee you lose about <1%/year in inflation adjusted (real) value. Of course, if interest rates increase the fund will progressively replace its bonds with higher paying ones and you could get a positive real return. If interest rates collapse again, your fund's value will jump nicely (good if you want to sell it) but you'll be stuck with a bunch of very low yielding bonds until rates rise again. Bond holders should want rates to rise, so that their bonds are yielding more, but they need to understand duration and that the overall duration of all your bonds should not be too long for your circumstances (or you don't get to reap the benefit of the interest rate rises).

[GeoffF100]

I'm not claiming the return is locked in for the ETF. I'm sorry if I didn't make that clear enough though I feel I tried. The return is locked in for bonds held to maturity and you can choose a bond with one year to maturity, or two years to maturity, or yes twenty years to maturity.

True but completely irrelevant to the discussion which is not about holding to maturity, that's all I'm saying...

GS

Is not the real point that a fund is unlikely ever to hold a security to maturity, but willl switch to later maturities as time passes?

As there is a wide range of maturities, the whole thing becomes increasingly obscure.

The ETF tracks the Bloomberg UK Government Inflation-Linked Bond Index, so it will hold all the bonds to maturity, and buy all new issued bonds within the remit of the fund. When it buys new issues, it will have to sell the same proportion of every bond holding to realise the money to make the purchase. When a bond matures, it will have to buy a fixed proportion of every bond holding to absorb the realised capital.