Skandia UK - Linkers. Expensive? ...Get real!

Stephen Jones takes a look at what negative real yields in the index-linked gilt market really mean.

With most index-linked gilt prices equating to next to zero or negative real yields, it is not surprising that cries of ‘aren’t they expensive’ can be heard. This knee jerk reaction may be right when comparing current yield levels available in the same assets to just a short time ago. However, considered from a broader perspective the answer is far from clear. Indeed there is nothing unusual in negative real yields; other assets have offered these for some time, and that has not prevented strong performance.

Index-linked Bonds closing price and yield

On other measures, and many possible inflation scenarios, index-linked bonds look good value. Relative to the long-dated fixed coupon gilt market, index-linked bonds have been underperforming since the middle of last summer. The boisterous rally in conventional gilts with maturities over 20 years has left linkers plodding along like the proverbial tortoise to the hare. A key measure of this – the so called ‘break even’ inflation rate which measures the inflation needed over the life of the investment before you would be better off owning the index-linked bond rather than similar maturity conventional gilt – has moved from 380 basis points (bps) in July 2011 to just 310 bps today for long-dated bonds. This underperformance of 70 bps makes index-linked bonds as cheap compared to conventional gilts as they have been since a spike to similar levels in late 2008.

Furthermore, negative real yields have been prevalent at the short end of the index-linked gilt market for some time now. This has not stopped impressive total returns accruing to holders of these securities. Index-linked 2016 dated bonds for example, yield -2.18% real and have had a negative real yield since September 2010, but have still produced a total return in excess of 10% year-to-date. Increased accrual of the redemption value and the small amount of interest paid in coupon within the bond on the back of high inflation rates last year, have combined with falls in market yields to drive through this impressive investment return. In many ways this represents the true appeal of index-linked bonds in inflationary times. Better to get some protection from inflation than none at all, even if it is with a negative real yield.

In addition, the inflation scenarios we face in the long term look as worrying as ever. Whilst Sir Mervyn King and the Monetary Policy Committee have staked much credibility on inflation coming down over 2012, it will do so from such a high level that its effect will still be significant. And all this assumes that the committee’s poor inflation forecasting track record can now be put behind them. Inflation will come down, but to pin all on a rate that is no higher than 2% in two years time after such a period of unexpected and persistent inflation, might be unwise for both the Bank and investors.

Part of the solution to the long term rebalancing of the economy also appears to be a generic central bank tolerance of inflation, alongside a complete intolerance of deflation. While not explicit yet, the Bank has already begun to acknowledge and gently debate the fact that single dimension inflation targeting might not be suitable in the future. A softer, more holistic approach to managing the economy might be more appropriate, one that is more tolerant of inflation going forward as it helps lessen the debt burden and speed the still necessary debt deleveraging we need. Index-linked bonds issued by a credit worthy sovereign remain the only backstop against an inflation error that starts off with good intentions around stimulating growth and ends in the long term with prices rising more enthusiastically than imagined.

Finally, we live in a world where low returns are part of the economic and policy playbook, and where negative real yields are the only return available in any sort of safe asset. And of course negative real yields encourage holders of these assets to move into higher return, riskier investments. Therefore, it shouldn’t be a concern when linkers dip into negative real yield territory. Linkers are simply enshrining what nominal government bond markets have done and what policy makers want (and need) to happen. Given the scale of the problems we face, we need to get used to negative real yields on linkers, and not let that put us off the very attractive inflation hedging attributes of the asset class.

Stephen Jones is Joint Head of Fixed Income at Kames Capital.