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An Inflated view?

Over the last couple of weeks, I have been looking at the risk and reward features of fixed-interest gilts and discussing the past and expected future returns and volatility, highlighting in particular comparisons with deposit-based investments.

This week, I want to stay with Government bonds but move on to the index-linked version. Index-linked Government bonds are, like their fixedinterest brethren, loans to the Government issued with a nominal value of £100.

However, unlike their fixedinterest equivalents, this £100 nominal value is not the amount at which they will be redeemed at a stipulated date in the future. In fact, the redemption price paid by the Government is the initial nominal value of £100 plus an allowance for the rate of price inflation between (broadly) the date of issue and the redemption date.

To give an example, the Government issues a new index-linked gilt with a redemption date 10 years in to the future. Subsequently, over that 10 years, price inflation rises by 73 per cent. The redemption price paid by the Government to holders of the gilt at the end of the 10-year period is £173, that is, the nominal value plus an allowance for the 73 per cent inflation.

The investor therefore knows that if he holds the bond to its redemption, he will get £100 in spending power in today&#39s terms although he does not know in advance, of course, how much this will be in future cash terms.

A typical example of an index-linked bond is the 2.5 per cent 2009 issue.

The title means that the bond will be redeemed in 2009 at £100 plus (as we have noted earlier) the rate of increase in inflation from the date the bond was issued until its redemption date.

In the meantime, it will produce a yield of, as the title of the bond implies, 2.5 per cent a year. However, that 2.5 per cent income is calculated on a year-by-year basis not as a percentage of the original and redemption – £100 – value of the bond (as with fixed-interest gilts) but as a percentage of its increasing nominal capital value which, as we have just noted, will be rising in line with increases in the RPI.

A further example should help to better illustrate this point. If inflation has been, say, 10 per cent during the year after an index-linked bond is issued, the nominal capital value of the bond will rise from £100 to £110 whereas in the first year following issue, the

income yield will be £2.50, that is, 2.5 per cent of £100, the income in the second year will be £2.75, that is, 2.5 per cent of £110.

Thus, it can be seen that not only is the investor&#39s original capital value protected but so is the income yield.

As with fixed-interest gilts, after the index-linked bond is first issued by the Government to investors, a second market is created within which the bond may be freely bought or sold. The price at which future transactions takes place will depend on the forces of supply and demand which here are in the main governed by how attractive investors consider the bond&#39s increasing income yield and the inflation-protected capital value.

In direct contrast to the forces dictating the market value of fixed-interest Government bonds, the driving force behind the fluctuating market price of the index-linked variety is the market&#39s expectation of future price inflation. If, for example, the market expects inflation to remain low, then demand for index-linked bonds will be low and the price will be depressed.

Note, though, that movements in the market price will in fact consist of a combination of this forward view and the fact that the nominal value of the bond is increasing each year. Moreover, much also depends on the attractions of these inflation-linked returns against competitor investments such as fixed-interest gilts and (as we shall discuss over the coming weeks) equities.

Thus, if interest rate returns on fixed-interest gilts are high, for example, the 13 per cent returns seen a couple of decades ago, then demand for index-linked gilts will tend to be adversely affected.

For example, five years after the issue of an index-linked bond (but still 10 years away from its redemption date), price inflation has risen by 30 per cent. The nominal value is therefore now £130. However, if at the same time there is widespread expectation of low inflation rates over the next 10 years, then the market price of this gilt may well fall significantly below £130.

This means the buyer gains not only the inflation growth on the nominal value plus the increasing yield on that value but also a kick-start profit being the difference between the price he has paid for the gilt and its nominal value.

Of course, this profit may turn out to be rather illusory if he attempts to sell the bond in the near future as he may have to sell at a discount to the nominal value if expectations of price inflation remain on the low side.

You should give some thought to this concept and ensure that you understand why the closer the index-linked bond gets to its redemption date, the closer the market price will get to its nominal (increased) underlying capital value (as the investor notes that nominal value is close to being realised or crystallised).

Fine but what about the historical returns on index-linked gilts and how do these returns, and their volatility, compare with the asset classes we have already discussed over the last few weeks? The table below, expanding on that shown a couple of weeks ago, answers these questions.

These statistics for indexlinked gilts are particularly interesting insofar as the best year occurred when inflation rates were historically low, at 2.75 per cent, and generally expected to remain so.

Of the near 20 per cent increase, only around 2.75 per cent can be accounted for by the increase in the capital value of the gilt, with the remainder being largely due to an improvement in the index-linked issues becoming more competitive against fixed-interest gilts as the market yield on the latter fell from around 6.35 per cent to less than 4.5 per cent.

This relationship explains why, in spite of returns from index-linked gilts usually being thought to depend on future expectations of inflation while returns from fixed-interest gilts depend on future expectation of interest rates, the two investments are moderately correlated. They are direct competitors for investors&#39 money, in particular, the pension schemes.

Returns from index-linked gilts and cash, however, are very lowly correlated. There is little theoretical or practical reason why their values should move in similar ways over any given time period.

So, index-linked gilts have historically given lower overall returns than both cash and fixed-interest gilts, with volatility considerably lower than the latter but broadly comparable with the former (slightly higher 1SD figure but less volatile at the very fringes of returns, indicating an overall steadier growth record).

Next week, we move appropriately on to commercial property as an investment asset class. I say appropriately as this investment option shares attributes with both indexlinked and fixed-interest investments.

You may want to consider why this might be so over the coming week.

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