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Index Link Securities

Stocks and Shares ISA , Choosing funds for ISA's, risk factors for funds etc
Investment strategy discussions not dealt with elsewhere.
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Index Link Securities


Postby billG » April 7th, 2021, 6:12 pm

Index Link Securities

What is the forums view on these?

I will kick this off with my views… (this is a tidied up version of a post I may on the citywire forum but wanted to cross post here).
TIPS (Treasury Inflation-Protected Securities) are US government Inflations Bonds. If held to maturity, are currently priced to lose you money in local currency terms. For instance for ITPS (iShares $ TIPS UCITS ETF), a basket of TIPS, the real yield is ~-1.24. Note for individual bonds issues the real yield will vary but general they all have negative yields. i.e. If what actually happens is the same as Market prediction you lose money.
It is a similar story for UK government Inflation Bonds (Linkers). For INXG (iShares £ Index-Linked Gilts UCITS ETF), a basket of Linkers, the real yield is ~-2.3%. The poorer yield can be partly explained by the fact that many pension providers are forced buyers of Linkers due to government legislation and these bonds are in short supply resulting in high prices and yields low. (The Government wants pension providers to match their future liabilities with ‘safe’ Linkers not ‘risky’ equities. Namely those people who are already drawing a pension should be protected. Whether this is a sensible policy depends on your viewpoint.)

For both TIPS and Linkers if the actual inflation is worse than expected then the actual yield will improve. If inflation turns out to be alot worse then you may even make a profit. But in general the best you can hope for is the inflation protection does not lose you money. Not very attractive if inflation stays in low single digits but with double digit inflation they are very valuable asset since most other investments will struggle to keep up.

Buying a basket of these in either a fund or ETF is a bit more complex due to the fact the duration of the individual bonds become shorter over time and eventually short duration instruments will mature and new bonds are added at the then prevailing bonds price that means the actual return over time varies making the actual return less certain.

Although TIPS are better value than Linkers they come with currency or FX risk. Typically the return from these instruments in normal times is swamped by the FX moves. So if you want to protect against inflation it is perhaps ‘best’ to buy a hedged TIPS basket. That said an unhedged TIPS basket may have an advantage in a market downturn for UK investors. The scenario goes like this: Equities crash; investors around the world sell their equity holding and buy something considered safe for instance US bonds of some kind (or gold). With more people buying dollars it pushes the USD up against GBP. In addition the FED will likely cut interest rates that raises mid-term inflation expectations so the price of TIPS will rise. So for the UK investor in sterling terms gets a more favourable FX rate with an asset that is rising in price. Bingo. This is the mechanics of the hedge that worked well for UK investors in the 2020 crash and in the Great Financial Crash. If this holds for the next downturn then unhedged TIPS may be a good hedge.

So in summary:
TIPS hedged = a reasonable proxy UK inflation but limited protection in a crash.
TIPS unhedged = a reasonable proxy UK inflation hedge but returns will be swamped by currency movements however would provide reasonable protection in a crash.

TIPS or Linker with a long duration will provide better protection and are more sensitive to changes in the inflation rate. But bonds with longer durations are more volatile of good or bad. To obtain the maximum protection you need a fair duration, say ~10+ years.
Now the other way to play the inflation hedge is to do what the traders do and make use of ETF such as:
Lyxor EUR 2-10Y Inflation Expectations UCITS ETF C GBP
Lyxor US$ 10Y Inflation Expectations UCITS ETF GBP
The Traders will have inflation and interest rate expectation estimates for various points on the yield curve: 3m, 6m, 1y, 3y, 5y, 10y,… They build a smooth curve and use this to value the future expected cash flows using a process called Net Present Value (NPV). i.e. If the annual interest rates were 1% a cash flow of £101 in 1 years’ time is it worth £100 today. Typically the curve will not just move up and down but bend and flex. It is known as the curve steepening or flattening. So if a Trader has a view which way the curve is going to flex they can use the Lyxor ETFs to make money. The advantage is that if the whole curve just moved up or down you do not make or lose money only when it flexes. So you are agnostic to general price movements to the whole curve. I suspect this level of sophistication is beyond the detail that most retail investors want to engage.

And there are, of course, there are gold and bitcoin bugs. Gold has worked MOST of the time but is volatile and can lose you lots of money if you get your timing wrong. Bitcoin is untested but MAYBE the new gold. There is evidence that suggests that bitcoin is more suited to rising markets and gold does well when inflation is rising more quickly than bond yields. If that is the case then gold is more useful hedge. I do not want to get into the pros and cons of gold and bitcoin here.

So the questions are:
Are you hedging against inflation?
If so how and what % of you portfolio is deployed to this purpose?
Are you planning to hedge against inflation?
If so how and what % of you portfolio are you planning to deploy to this purpose?

To answer my own questions
I have 1.5% in NS&I CPI inflation bonds (current not available otherwise I would buy more).
I have 3% in PNL/CGT which have maybe 45% TIPS (unhedged - I think but maybe wrong) and some gold. (10%/1% respectively)
What am I planning? My guess is inflation is coming but is not here yet. Peter Spiller and others were saying inflation was going to shoot up after the Great Financial Crash but they were wrong. That said I think they may be right this time. Any hedge (insurance) is costly until you need it of course. Buying a few percent more of inflation linked bonds is not going to make that much difference and it seems quite a position to take a large chunk (35+%) of money and deploy it now to blunt the effects of the inflation genie. So I am interested in views. Especially those who lived through the high inflation of the 70s and 80s and seen/experienced what inflation can do to your portfolio. I guess it will partly depend on where you are in the lifecycle of lifetime investing but have just finished my accumulation phase and about to embark on some sort of drawdown strategy.

Interested to see what others think.

Thanks in advance.

FYI here is a link where you can read about Mr Spillers views here about replacing bonds with TIPS. ... -news-list

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Re: Index Link Securities


Postby dealtn » April 7th, 2021, 6:20 pm

billG wrote:Index Link Securities

What is the forums view on these?

The poorer yield can be partly explained by the fact that many pension providers are forced buyers of Linkers due to government legislation and these bonds are in short supply resulting in high prices and yields low.

They aren't forced by legislation, but are certainly "encouraged".

UK linkers aren't particularly in short supply. Historically the Government (via its agents) are issuing many more than at any time in history. Furthermore, unlike alternatives, these aren't being "bought back" through the QE mechanism.

billG wrote:

So the questions are:
Are you hedging against inflation?
If so how and what % of you portfolio is deployed to this purpose?
Are you planning to hedge against inflation?
If so how and what % of you portfolio are you planning to deploy to this purpose?

No (at least not explicitly)
No (at least not explicitly)

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Re: Index Link Securities


Postby scrumpyjack » April 7th, 2021, 7:18 pm

Having lived through the 70s I am very conscious of what serious inflation does and of course in spite of all the claims of looming deflation, the pound has lost a lot of purchasing power since the GFE. Inflation is still here albeit not at the rates seen in the seventies.

I am not attracted to PNL or CGT, particularly as their holdings of TIPS and ILGs seem to guarantee a real loss, but have a reasonable holding of RCP, which is fairly conservative and aims to avoid the worse of the downs. It has done well in the past.

When higher inflation comes, it makes a lot of difference what currency you hold. Perhaps weighting to the Swiss Franc would be sensible. I would expect it to devalue much less quickly than GBP, USD and the Euro.

The other difference to the 70’s is that then my portfolio was virtually all UK, whilst today most of it isn’t. Also perhaps focus on companies that will be less affected by inflation (ie services and capital light businesses with strong moats and robust balance sheets).

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Re: Index Link Securities


Postby Hariseldon58 » April 7th, 2021, 8:37 pm


Good summary of the situation, my thoughts are why do you think market expectations are wrong ?

Very occasionally the market seems to go a little bonkers, overly optimistic or pessimistic, at those times I will come out and play and find profitable opportunities.

Personally I have no idea what will happen, you can make good arguments both ways and they seem reasonably in balance at present.

I sold a small holding of ITPS ( circa £70k) before Xmas and redeployed elsewhere this was a good move.

I have since added a further small holdings of INXG and ITPS recently, which I may add to, just as insurance to cover living costs in the event that there was unexpected inflation.

A few uncomfortable positions in a portfolio can provide some solace when the unexpected occurs.

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Re: Index Link Securities


Postby 1nvest » April 8th, 2021, 12:06 am

billG wrote:So the questions are:
Are you hedging against inflation?
If so how and what % of you portfolio is deployed to this purpose?

Yes, on a broader portfolio basis. With 25% weighting. In US scale the UK FT100 is mid cap and FT250 is small cap, so the UK version of that is S&P500, FT100, FT250, Gold. Maybe CSP1, VUKE, VMID, SGLN.

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