Gilts have generated especially high returns for investors due to the increased aversion to risk that has characterised markets since the summer of 2011.
In particular, investors have sought the protection of inflation-linked gilts in a horrible year for the Bank of England, where inflation has hovered at roughly the 5 per cent mark due to higher commodity prices and tax increases.
Data compiled by Morningstar for Investment Adviser reveals that inflation-linked, or index-linked, bond funds returned an average of 18.51 per cent from January 3 2011 to January 3 2012, compared with a loss of 1.21 per cent for the FTSE All Share equity index.
The top-performing funds of 2011 were mainly housed in the IMA’s UK Index-Linked Gilt sector. The top three performers were Baillie Gifford Active Index-Linked Gilt and Henderson Index-Linked Bond, which gained 23.98 and 22.29 respectively to January 3, followed by the M&G Index-Linked Bond fund, with a return of 22.22 per cent.
However, Mike Riddell, manager of the M&G fund, cautions against attributing all of the demand to last year’s high inflation. The Henderson Index-Linked Bond fund, for instance, profited by positioning for expectations of UK inflation over 30 years to rise against anticipated five-year inflation.
“Some people may jump to the conclusion that this [growth in demand] has been because investors have become increasingly worried about inflation, but this isn’t actually the case. In fact, the market’s inflation expectations have actually fallen over the last 12 months,” he says.
Stephen Jones, manager of the Kames Inflation-Linked fund, says: “There is some respite for the authorities in that in contrast to the recent past we haven’t had an upside surprise [in inflation]. Absolute price levels for goods and services though remain at much higher levels than a year ago.
“The consumer prices index has come in as most people in the market expected at 4.8 per cent year on year. However, the retail prices index at 5.2 per cent remains at painful levels. Inflation will fall, but there is still a lot to do before we get to more acceptable price rise levels, with much scope for disappointment on the way.”
According to George Henderson, an index-linked bond fund manager at Royal London, the relative low price of index-linked products has also contributed to their demand. The manager claims they are the cheapest available in the capital market and give fixed income investors a great opportunity to switch into them at low levels.
Mr Henderson also observes index-linked funds can generate extra returns by managing their duration, or their exposure to the risk of interest rates risking. For instance, he kept his duration short in overseas index-linked gilts as long-dated UK inflation linked bonds’ real yield reached negative levels.
Mr Riddell says the biggest driver of performance on his fund last year was maintaining a long duration position, or exposure to the risk of interest rates rising.
He says: “About half the index-linked gilt funds that are available for retail investors, including the M&G Index Linked Bond fund, are managed against the FTSE UK Gilt Index-Linked Gilt index, where the index duration is 17.7 years. The other half of the index-linked gilt funds are managed against the FTSE UK Gilt Index-Linked Over 5 Years index, which has an even longer duration of 20 years.
“The performance enhancing benefit of duration can be seen by a look at the recent return of longest maturity index-linked gilt, a new index-linked gilt that matures in 2062 that was issued in October of 2011. The fund has a duration of 45 years and had a real yield of 0.49 per cent. In just over one month, the yield on this bond had fallen to the extent that it became negative, yielding -0.15 per cent, and because of the bond’s very long duration the bond had returned almost 30 per cent,” Mr Riddell adds.
In spite of UK index-linked bonds currently offering negative yields, managers do not believe they offer poor value in the long term.
Mr Riddell says there is still a lot of scope for UK index-linked gilts to rally if the Bank of England keeps interest rates low for a long period, particularly as rising inflation might still re-emerge.
“There are upside risks to UK inflation in the medium and long term. The bond markets are pricing in very little inflation, and therefore inflation-linked gilts still offer relatively good value.”
However, he adds that in case the Bank of England raises its interest rates in the wake of an economic recovery, index-linked gilts would not be any better than the conventional gilts.
“I expect index-linked gilts to fall further from here, so in my view the outlook is still positive, although index-linked gilts are not as attractive as they were a year ago.”
Mr Henderson says a recovery in the economy could also hit government-backed index-linked bonds in particular. “The risk to inflation-linked bonds going forward is an increase in risk appetite.
“The attractiveness of the government backed securities in such an environment will be lessened.”
In such a situation, he suggests switching UK inflation-linked bonds into global inflation-linked products, which are cheaper and have lower duration.
Ben Seager-Scott, senior analyst at Bestinvest, also recommends index-linked corporate bonds over index linked gilts, as safe-haven buying has pushed the prices of conventional and index-linked gilts to unattractive levels.
He says that the factors that affect inflation-linked gilts also affect the inflation-linked corporate bonds and the price is inversely proportional to yields for both kinds of bonds, “since the price is broadly high right now the yields are unattractive”.
Still, if investors want exposure to corporate bonds that are index-linked, then Mr Seager-Scott would recommend the M&G UK Inflation-Linked Corporate Bond fund. He says the M&G product favours short duration exposure and hence is less sensitive to rises in interest rates.
With the outlook for inflation so uncertain, investors should bear in mind UK interest rates will not stay at their record lows forever.
Mitali Patel is a freelance journalist
