Paid post by Allianz Global Investors

Your index-linked gilt fund may not be as risky as you think

Index-linked, or inflation-linked, gilts can play an important role within an investor’s portfolio, and are a distinct asset class to conventional gilts. While index-linked gilts have a higher duration compared to their conventional counterparts, this duration figure is misleading as inflation-linked bonds do not tend to move in line with their conventional counterparts. Key to understanding how these bonds will behave is knowing what the yield betas of your index-linked gilts are.

Index-linked, or inflation-linked, gilts can play an important role within an investor’s portfolio, and are a distinct asset class to conventional gilts. While index-linked gilts have a higher duration compared to their conventional counterparts, this duration figure is misleading as inflation-linked bonds do not tend to move in line with their conventional counterparts. Key to understanding how these bonds will behave is knowing what the yield betas of your index-linked gilts are.

The yield beta is a measure of how much the inflation-linked gilt’s yield changes relative to a move in the conventional yield. We’ve plotted this on the chart below showing 10 year conventional gilt yields versus 10 year index-linked gilt yields. Between 2007 and 2009, the yield beta for index-linked gilts was 0.39, meaning that for every 1 percentage point change in the yield of conventional gilts, the index-linked gilt yield would change by 0.39 percentage points.

Source: Allianz Global Investors, Bloomberg, 05/01/2007-29/12/2017.  Past performance is not a reliable indicator for future results.

What this means is that, despite often having a higher duration, the index-linked yield would move less than the conventional yield, reducing some of the interest rate risk on the bond. If you own index-linked gilts within a portfolio of conventional bonds, you can adjust the index-linked duration by the yield beta to get a comparable level of interest rate risk. If we use the yield beta to adjust the duration of a 10 year linker with that of a conventional, the effective duration of the linker comes out lower than that of the conventional, having been higher before.

The yield beta can change much more than this however, particularly when driven by large changes in inflation expectations, and hence breakevens. We can break down the latest of the above periods into 4 distinct periods, which gives us very different yield beta assumptions for each. Underneath the chart below is a table detailing the yield beta for each period.

Source: Allianz Global Investors, Bloomberg, 07/06/2013-29/12/2017. Past performance is not a reliable indicator for future results.
Source: Allianz Global Investors, Bloomberg, 07/06/2013-29/12/2017.

Following the Brexit vote, higher inflation expectations meant that breakevens increased and index-linked yields moved more than conventional. Conventionals then sold off aggressively as UK gilt yields were lifted with global government bonds in the run up to and following the US presidential election. Since then, the yield beta has been around 0.7.

Yield beta assumptions are crucial to understanding and forecasting the total return potential of your index-linked gilt allocation, and are important for calculating an index-linked bond’s interest rate sensitivity. Yield betas tend to differ for different maturities across the yield curve, and even across different countries’ inflation-linked bond markets.  This has been one area of focus for our Allianz Gilt Yield strategy, the market-leading conventional gilt fund which has the ability to hold exposure to index-linked gilts(1). We will also be launching a sister strategy in February which will primarily be focused on index-linked gilts – the Allianz Index-Linked Gilt Fund. Suited for investors with an index-linked allocation in their benchmark or who are looking for inflation-protection, the Fund will have an ‘early-bird’ share class with fees of 0.20%, which we believe to be very competitive with the passive funds in the sector.

The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. Investing in fixed income instruments may expose investors to various risks, including but not limited to creditworthiness, interest rate, liquidity and restricted flexibility risks. Changes to the economic environment and market conditions may affect these risks, resulting in an adverse effect to the value of the investment. During periods of rising nominal interest rates, the values of fixed income instruments (including short positions with respect to fixed income instruments) are generally expected to decline. Conversely, during periods of declining interest rates, the values of these instruments are generally expected to rise. Liquidity risk may possibly delay or prevent account withdrawals or redemptions. Past performance is not a reliable indicator of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor’s local currency. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or wilful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail. This is a marketing communication issued by Allianz Global Investors GmbH, www.allianzgi.com, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch, 199 Bishopsgate, London, EC2M 3TY, www.allianzglobalinvestors.co.uk, which is subject to limited regulation by the Financial Conduct Authority (www.fca.org.uk). Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

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‘Further information on Mike Riddell and our Allianz Index-Linked Gilt Fund can be found by clicking here

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_____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ (1) Since Mike Riddell and team took over management of the Fund, (30/11/2015-29/12/2017). The Fund is the top-performing conventional all stocks gilt fund in the IA Gilt Sector, Source data: Morningstar.