Investing in index-linked bonds - ii (2024)

FAQs

Are index-linked bonds a good investment? ›

Index-linked bonds provide valuable protection against inflation, giving investors an income that is positive in “real” or inflation-adjusted terms.

Inflation-linked bonds work by increasing their cashflows in line with an official inflation index. For example, if the inflation index jumps 5% then an index-linked bond's principal and coupon payments will also climb by 5%. This mechanism ensures the bond's returns keep pace with rising prices.

With the ECB forecasting inflation to be 2.5% in 2024, 2.2% in 2025, and 1.9% in 2026, a 2-year German inflation-linked bond should yield approximately 3.7% in nominal terms. When this return is hedged back to GBP, as we typically do, the return could be around 5% in sterling terms, which represents excellent value.

You can make purchases via financial or trading platforms. Ensure that the financial services that offer UK Index-linked gilt ETFs are authorised and regulated by the financial conduct authority (FCA). You can also speak to financial advisers for more information about existing UK gilt portfolios.

The problem is that bonds and inflation do not tend to get on well. Inflation encourages central banks to tighten monetary policy and raise interest rates. If interest rates rise then bonds become less attractive.

Market Risk: Investing in inflation-indexed bonds carries a degree of market risk, as fluctuations in interest rates and economic factors can impact their prices. Liquidity Risk: These bonds may have lower liquidity than regular bonds, making it challenging for investors to sell their holdings when necessary.

And just like conventional Treasury bonds, TIPS are impacted by movements in the interest rate marketplace. If Treasury yields increase because of rising inflation, TIPS are hedged. But if yields increase because of rising real yields, as we have right now, TIPS are susceptible to losses.

Calculating the yield on an inflation-linked bond is quite similar to any other bond, except the real yield and not the nominal yield is used. To find the real (rather than nominal) yield of any bond, calculate the annual growth and subtract the rate of inflation.

Because bond prices typically rise when interest rates fall, the best way to earn a high total return from a bond or bond fund is to buy it when interest rates are high but about to come down.

Is now a good time to buy bonds? ›

If an investor is looking for reliable income, now can be a good time to consider investment-grade bonds. If an investor is looking to diversify their portfolio, they should consider a medium-term investment-grade bond fund which could benefit if and when the Fed pivots from raising interest rates.

Impact of Inflation on Fixed Income Investments

Bond prices are inversely rated to interest rates. Inflation causes interest rates to rise, decreasing the value of existing bonds. During high inflation, bonds yielding fixed interest rates tend to be less attractive.

Conventional and index-linked gilts

Interest received is taxable and must be declared on tax returns. This includes the interest uplift on index-linked gilts. But the uplift in principal as a result of index-linking is not interest, and is not taxable.

Index-linked Savings Certificates are lump sum investments for a set period of time called a 'term'. If you keep your investment for the whole term and don't make any withdrawals, your money will be guaranteed to grow ahead of inflation.

Bottom Line. Investing in bond index funds can be one way to increase your exposure to safer, low-fee securities. But you may also encounter some hidden risks. Bond funds that invest heavily in government-backed securities, for example, may be highly volatile in a high interest rate environment.

If you keep your investment for the whole term and don't make any withdrawals, your money will be guaranteed to grow ahead of inflation. Each year their value moves in line with a measure of inflation called the Retail Prices Index (RPI).

As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets. If your bond ETF loses value, you can wait out the interest rate changes or reallocate to money market accounts (MMAs), certificates of deposit (CDs), or high-yield savings accounts.

These bonds are designed to provide returns that adjust with inflation, thereby preserving the purchasing power of your money. By offering a guaranteed rate of return above inflation, they ensure that your investment grows in real terms.