Why have returns from inflation-linked bonds been so abysmal?

Sadly, as the table shows, the story has been very different.

Had you bought 50-year inflation linked bonds at the beginning of the year, you would have lost more than half of your money. They have underperformed even their non-inflation-linked equivalents. Why?

Table 1: Year-to-date returns from UK gilts

Inflation-linked bonds derive their returns from three elements, the first two of which they share with ‘conventional’ bonds:

1. Income (a function of the ‘coupon’).
2. Capital gains (or losses).
3. The inflation accrued over the holding period.

Inflation-linked bonds are bonds first and foremost; they are a form of inflation protection only second. And 95% of the time, they move in the same direction as conventional gilts.

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. The result can be especially painful for longer-maturity bonds.

This year’s inflationary surprises have increased the value of inflation-linked bonds relative to nominal bonds. At the same time, though, those inflation surprises have also triggered a far more forceful response from the Bank of England, driving down the value of longer-maturity inflation-linked bonds.

The overwhelming driver of total returns for long-duration inflation-linked bonds is not inflation accrual – but the capital gain (or loss) derived from the move in yields. This can be most clearly seen in the case of the 50-year inflation-linked bond due to mature in 2073. Its yield has risen from -2.5% at the start of the year to -0.28%, resulting in a loss of 60.9%.

Rising interest rates are less damaging for short-maturity bonds, where inflation accrual plays a bigger role. This is why – year to date – inflation-linked gilts with two years to maturity have generated a healthy return of 4.8%, while the equivalent conventional gilts have lost 4.0%.

Managing expectations

Another point: changes in the market’s inflation expectations often matter more than actual inflation. So if you are debating whether to buy inflation-linked bonds, your decision should be determined less by the actual level of inflation and more by your expectations of how inflation will evolve relative to the bond market’s expectations.

For example, on 21 October the January 2028 nominal gilt yielded 4.11%, while the inflation-linked gilt with the same maturity yielded 0.21%. So the market was suggesting that RPI will average 3.91% over the next six years. We call this the ‘breakeven’.

You should only consider owning the inflation-linked bond relative to the conventional equivalent if you believe that average inflation over the next six years will come in higher than the breakeven of 3.91%.

There is one significant exception to this rule. There may be times when we do not expect inflation to exceed the market’s expectations – but we want some insurance against that being the case. The higher inflation reaches, the more unpredictable it tends to become, increasing the value of the option of owning inflation-linked bonds relative to nominal bonds.

Is there any point in investing in inflation-linked bonds?

Unquestionably, yes. There are usually two good times to invest in what is a highly technical market.

1. During QE. Quantitative easing tends to be good for all asset prices but it is incredibly supportive for inflation-linked bonds. This is particularly the case if you buy inflation-linked bonds close to the initial announcement of QE. Central banks usually announce QE when disinflationary fears are at large and inflation breakevens are below central banks’ targets. Printing money under QE increases the skew of inflation to the upside.
2. In a stagflationary environment. At some point, central banks might have to shift their focus away from controlling inflation and towards supporting growth. Once unemployment ticks higher, central banks may – either voluntarily or under political pressure – tighten policy less than expected or start loosening it. If inflation breakevens at that time are compelling then inflation-linked bonds could perform well.

So when you buy inflation-linked bonds – and what maturity of bond you buy – makes a huge difference to your total returns. Most have had a poor year in 2022, but the time to add some inflation protection to your portfolio again might not be all that distant.

Juan Valenzuela is manager of the Artemis Strategic Bond Fund.

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