UK Index-Linked Gilts 101
The pain of inflation got burned into our brains in 2022. Most people had a significant portion of their wealth eaten away by inflation last year and well done to you if you grew your wealth ahead of the rate of inflation last year.
On that point, we all invest to try and achieve a positive ‘real’ return, i.e. a positive return after accounting for inflation. However, last year, every asset and asset-class saw increased volatility compared to most times in the past decade and there’s uncertainty everywhere.
Wouldn’t it be great if you could find an asset that gives you income, high certainty of getting your money back and adjusting the two for inflation? It’s not perfect, but there is an asset that advertises such amazing characteristics and they are inflation linked bonds issued by certain governments.
I specifically looked into UK’s Index-Linked Gilts (in other words Inflation Linked Bonds), because they’re easiest for me to trade and access, and I’m going to explain how the instrument works. Also, these gilts are fondly referred to as “linkers”, which is what I’ll refer to them as for the rest of this post.
The payoffs
Unlike most equities, it’s much easier to answer the following questions when it comes to bond investments
Who issues it and pays it back?
How do they pay it?
What you pay to buy?
What you get paid?
What incentive do they have to pay you back?
Let’s try to answer these questions briefly from the perspective of linkers -
Who issues and pays it back?
The UK government issues this debt and they pay debt holders both the coupon as well as the principal upon maturity.
How do they pay it?
Through tax receipts and government borrowings.
What you pay to buy?
There’s 2 different possibilities here which are explained at a very high level -
Buying during issuance (you can skip this part if you’re more likely to buy a bond on an exchange) -
During the issuance of a bond, the issuer of the bond (ie the borrower) will announce that they want to issue a certain notional amount (usually it will be $100 or £100 in this case) and at a certain rate
Investors (ie lenders) will ‘subscribe’ to the issuance similar to an IPO for a newly listed stock. In cases where the issuance is an auction, the investor will specify what rate they want to buy it at
If the issuance is oversubscribed, investors are likely to buy the bond for more than £100. In this case, the issuer is able to borrow more for cheaper
If the issuance is undersubscribed, investors are likely to buy the bond for less than £100. In this case, the issuer is required to borrow at a more expensive rate
Buying while the bond is trading in the secondary market -
In this case, the bond has been purchased from the issuer and eventually some of those bonds make their way to an exchange or secondary market to trade
In the case of linkers, some issues are found on the London Stock Exchange
These types of bonds are quoted with a ‘Clean Price’ which is the price that you pay to receive the ‘Yield to Maturity’ quoted on the price. (More on how bond yields work here)
What you pay though, would usually be a ‘Dirty Price’. For a traditional bond, the Dirty Price is the Clean Price + the pro-rated interest payment that you are due to receive. Hence, the day after the day you receive the full annual interest payment on the bond, the Clean Price = Dirty Price
However, for linkers, the Dirty Price also includes the inflation component in addition to what’s described above
What you get paid?
On a traditional bond, you will get paid
the interest on the bond aka the coupon listed on the bond
and
the principal on the bond is repaid upon maturity
On a linker, both these payments are adjusted for inflation. A crude way of understanding how the inflation adjustment is done is as follows -
The UK’s inflation gauge is the RPI and this RPI’s level is marked at the time the linker is issued
On the day the interest payments are made, the DMO (who is the issuer of all the UK Govt. debt) uses an indexation methodology to find the current RPI to use
A ratio is calculated between the RPI specified in 2 and the RPI specified in 1 described above
The interest payment is multiplied by this ratio and that’s the adjustment that’s made to the interest payment
Upon maturity, the index ratio is calculated similarly and that ratio is multiplied by the nominal face value of the bond (ie £100). This index ratio based adjustment is the inflation adjustment
The calculation for the RPI for indexation purposes, is described in the DMO website here.
What incentive do they have to pay you back?
This may seem like a stupid question but it’s one that I’d ask if I was investing in a stock so I’ve included it here to stay consistent.
The world today has so much debt that a considerable portion of that debt can only be repaid via more borrowing. It doesn’t seem sustainable, but it’s the truth for a large part of the world. This is particularly true of the developed nations like US, UK, Japan and the EU as well. With the competition from the UK’s peer debt issuers, they can’t take a chance and miss an interest payment or the principal repayment because if they do, they will permanently lose a segment of UK debt buyers forever. Plus it’s a point of pride as well so I don’t see them defaulting on these or any of their bonds.
They’re also trying to be responsible with their borrowing and finances which is what’s leading to tax hikes and lack of borrowing which is leading to smaller pay hikes for most government workers (which I believe is the cause of the strikes).
Conclusion
I hope you found this overview useful. I struggled to find a good guide on the mechanics of these bonds and I wrote this post to serve as my own notes on the back of the reading that I’ve done. I’ve written a post about my Index-Linked Gilt trade idea. I’ve also found that these gilts trade in very counter-intuitive ways (particularly from 2022 onwards) and I came across this excellent post which dissects the correlations that they have with regular gilts as well as some of the reasons behind these dynamics. I strongly recommend you read this post if you are interested in holding these gilts as it will help save you the brain pain of trying to figure out why they’re behaving so oddly.