Index-linked gilts and their us equivalents, Treasury inflation protected securities, are widely misunderstood but attractive investments
Dear Sir/Madam, Would you like some good TIPS, free of commission, designed to profit from inflation?
Normally that is opening gambit in the sale of some sure-fire money-losing scheme or other. However, in this case, it is for government bonds. In this case the capitals are not hype but the acronym for Treasury inflation-protected securities in the US – index-linked gilts in the UK.
In this month's column I shall explain the basics of this little known and widely mis-understood segment of the market, because it is likely to become increasingly important.
It is an old truth in financial markets that what is widely advertised is not worth buying, while what is overlooked is probably a fine investment. On this basis, those who invest in bonds should run for their lives, because the financial press is full of advertisements for high-risk bond funds at record low yields.
long term means long term
This scepticism about the outlook for bond markets is reinforced by the fact that governments around the world are issuing bonds with a life-span of 50 years for the first time in half a century.
In the UK, the Chancellor's Christmas present to the City was consultation about the possibility of issuing 50- year gilts. However, the European's beat him to market. Greece, a former emerging market, jumped the gun by announcing a 30-year bond at the end of February, while the French government issued the first 50-year bond. This therefore is the time to debunk a few myths.
what is the Track record?
If index-linked bonds are a new and untested investment medium, is it not prudent to wait till they have established a track record? It is true that among the G7 countries, the Japanese government only announced the first yen bonds in January 2004, but France issued the first Euro-denominated issue in October 1998 while the US began issuing them at the start of that year. Canadian dollar issues have even been around since November 1991.
However, the UK is the longest-established market. Index-linked gilts have been available to the general public since May 1997, and a restricted £1 bill issue was offered to pension funds as long ago as March 1981.
It is arrogant to think that the world's most developed markets must be the source of all financial innovation. In this case, the early leaders were desperate, and often emerging, governments, for whom conventional bond issues in domestic currency markets were unsellable. These included New Zealand in 1977, Brazil in 1964 and Israel as long ago as 1955.
heed the warning signs
If investors should avoid new issues of government bonds, surely the growth of this market segment implies poor future returns?
Normally, yes, when issuance is at high and record levels. Between 1997 and 2004, the issuance of TIPS has soared almost tenfold from $25bn to $200bn, so issuance is high by historic standards. By the end of this decade, the US Treasury expects it will be issuing almost as much in TIPS as in conventional paper. Then it will be high in absolute terms.
However, we are not there yet. This is still a minority taste, largely restricted to pension funds. Even though there are 22 governments that have now issued index-linked bonds in their own currencies, I cannot find a single global index-linked fund on sale to retail investors. That is the reason why scepticism about new issues is misplaced in this market segment.
Index-linked bonds are the last resort for governments, whose voracious appetite for savings is meeting investor resistance. After all, what government would voluntarily give up the option of devaluing its own debts through future inflation, as the UK government did to investors in War Loans, the most notorious of undated gilts?
Consumer price index
If these bonds are linked to inflation, surely investing in them will be as boring as watching the consumer price index (CPI) rise?
No. Both the annual coupon and redemption price on maturity are adjusted to the CPI, but that redemption price may be many years away, so meanwhile prices may fluctuate to adjust for investor's changing yield expectations. Table 1 is a sample selection of benchmark bonds, and it shows that yields have fluctuated in a range as wide at 0.5% to 5.0%.
That can generate big swings in prices, even with little or no inflation. This is shown in Graph 1, which highlights price movements for a similar sample selection of linkers, when stripped of changes in CPI. The most spectacular rise was for the long-dated UK issue after Black Wednesday in 1992, when the sterling collapsed. Between August 1992 and January 1994, its price rose from £96 to £125.
Given the increasing likelihood of a similar crisis after the present election, a comparable capital gain may well lie in store for UK investors in this segment of the gilts market.
Further price swings
Big price swings have also been recorded elsewhere. Over the same period, the Canadian government's issue rose from C$93 to C$113. However, there is equal scope for loses. In relative terms, that issue fell to C$88 during the following year. Such changes are not necessarily directly related to inflation.
The biggest surprise is seen when comparing the longest dated conventional and index-linked issues in the most diverse market, namely the UK. During the great bonds bull market, one would expect that the price of the most volatile conventional issue would outperform its index-linked peer.
However, that is not so, as seen in Graph 2, which compares War Loans to the index-linker maturing in 2024, both rebased to 100 when the latter was issued in 1987. The conventional bond appreciated 110%, while the index-linker rose 167%.
What factors influence the movement of index-linked bond prices? Apart from the ratchet effect of changes in the CPI, the biggest variable is the yield demanded by investors, as shown in Table 1.
Market expectations are heavily influenced by the real yield on conventional long-term bonds. Over the past decade, investor confidence has grown that inflation will stay low. While inflation in the US first fell below 5% in 1991, it has taken until now for yields to fall from 8% to 4%. Graph 2 illustrates that, in the short term, movements in the prices of both types of bond can be closely correlated, using the example of the UK. During the 1994 setback, the conventional bond fell 29% while the index-linker fell 15%, almost half as much. However, in the 1999 setback, while the conventional bond fell almost as much at 27%, the index-linker fell only 5%.
On the other hand, in the 2003 setback, where the conventional bond fell 20%, the index-linker actually rose 5%.The key issue is the break-even inflation rate. This is currently around 3% in most countries. If you think it will be higher during the life of the bond, buy the index-linker, if lower buy a conventional issue of a similar maturity.
Then there are pricing anomalies. Normally one would expect that the longer the maturity the higher the yield to compensate for the greater risk of price fluctuations. However as the XY scatter (Graph 3) shows, some bonds are priced well away from the normal yield curve. For example, the longest-dated UK issue appears to be selling on too low a yield basis.
That is due to the extraordinary demand for long-dated conventional gilts, thanks to a dysfunctional market for pension liabilities. Where demand has driven yields well below those initially offered, approaching maturity act as a dampening influence. With only three years still outstanding, the US 3.625% index-linker is beginning to suffer this effect.
As reflected in the chart of international comparisons, in the last year its price has fallen from $113 to $107.
investing in practice
That sounds great in theory but there is so little information available, so how would one go about investing in practice?
Here, too, the Companies and Markets section of the Financial Times provides a selection of vital statistics on the most important index-linked bonds in different currencies within its Market Data page.
The best websites are that of the Debt Management Office in the UK (www.domo.gov.uk or www.dmo.gov.uk). There is also the Bureau of the Public Debt in the US, (www.publicdebt.treas.gov or www.publicdebt.treas.gov). These bonds can be bought through stockbrokers. Indeed, individuals can even apply direct to the government, so these particular sure-fire money-making investments (as long as inflation exists) can be bought free of commission.
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