Do you think it was a bad year for UK equities? Just be grateful, you may have money tied in gold-edged stocks. And, if you had money on vanilla gilts, be thankful for that too – you might be invested in the indexed variety.

Of course, it’s not meant to be that way. The whole point of investing in UK government-backed index gilts is that they are meant to be an all-season source of capital. Specifically – and as the name suggests – they offer protection against investors’ most insidious enemy, inflation. They do this based on their structure, meanwhile removing one unknown from any investor’s calculation: how much to allow for the erosion of purchasing power when evaluating likely returns on investments.

Well, yes, most of the time indexed gilts do just that. But most of the time, that’s not all, and when a herd of black swans comes close to sight, even the most plausible investment theory backs off. So, in the last year or so, a sequence of supply constraints courtesy of first Covid closures and then that nice Mr. Putin, followed by the UK-focused effect of Trussonomics, have conspired to give a hangover to the gilts. But, for those holding index stocks, the experience must have felt more like waterboarding.

Table 1 shows the key facts, using price data from two exchange traded funds (ETFs) that track the indices of conventional gilts and index-linked gilts. The surprise is that the best and worst 12-month percentage changes for the index gilt fund are more extreme than those for the conventional gilt ETF. With this year’s development, for both asset classes the evil has gotten progressively worse and the index fund has experienced 10% worse year-on-year price drops for seven consecutive months. These are the only seven drops of more than 10 percent in all 110 months under review, and each subsequent decline was worse than the last. It’s safe to say that in the 40 or so years of indexed gilts in circulation, they haven’t endured a more miserable time.

TABLE 1: LINKERS AGAINST AGREEMENTS
% Change over 12 months (2013-22) iShares Core UK Gilts IShares Indexed Gilts
Improve 14 25
Worse -26 -37
Average 1 3
St’d Dev’n (%) 8 11
+1 St Dev (%) 8 14
-1 St Dev (%) -7 -7
Periods of 12 months 110 110
Falls of more than 10% 7 7
1 every ‘x’ years 1.3 1.3
Source: iShares

As for the reason, we can blame human nature for this torture by indexing. It is perfectly fine to say that “linkers” remove the risk of inflation from a stock’s returns, therefore, their price movements should be moderate. But index-linked gilts are not “granny bonds,” the inflation-indexed savings certificates issued by the government from 1975 to 2010. Their “prices” did not move because grandny bonds were non-negotiable. Indexed gilts are tradable and, as such, exposed to all the follies that maniacal bettors can throw at them.

Also, those bettors aren’t trading the current level of inflation. They already know what it is. They negotiate predicted inflation ‘x’ years in the future. So when they fear – for good or bad reasons – that, say, in two years’ time inflation will last at 6% instead of the benign 2% they have been used to discounting for so long, then prices have to adjust by decreasing. drastically. There is no other way and it does not matter that eventually the emerging inflation rate will be taken into account in both the dividends and the principal repaid.

As a matter of fact, when inflation rises, bettors want higher real returns to offset the additional risk and can only get it if they buy at a lower price than before. A real yield – higher than inflation – of even around 1% for a government bond might be fine when inflation is low. But when it exceeds expectations, real returns must be higher. This is also why, for example, the Treasury could get away with issuing index-linked shares with coupons (the interest rate) of just one eighth of a percent in recent years. Conversely, when inflation expectations were higher, coupons regularly had to be above 2%. For example, the bond with the highest coupon of all linkers, Treasury 4.125% 2030, was issued in mid-1992, when the UK’s inflation rate had been challenging 10% just a year earlier. Higher coupon days, in line with higher interest rates, are very likely to come back.

However, after the worst seven months on record, it is almost inevitable that thoughts turn to the idea that indexed stocks may now be cheap, just as we recently discussed in relation to the conventional variety (‘The Case of Gilts, IC 21 October 2022). However, one particular difficulty relates to the evaluation of linkers. This is that the data on the likely returns they offer is both inaccessible and, frankly, unreliable.

In part, this is due to the fact that it is a bit more complex to calculate the yield to maturity on an index-linked security than on a conventional one. The goal is to calculate a ‘real’ return, which removes the effects of inflation from the result. To do this, it is necessary, first, to include in the mathematics an assumption for how quickly the value of dividends and capital will increase. Hence the assumed inflation rate must be subtracted from the nominal yield obtained. True, one could assume an inflation rate of zero, but that might be a bit unrealistic.

More specifically, the data providers do not specify the presumed inflation rate they consider in their sums to calculate the payback yield. As a result, some odd numbers emerge. Take, for example, the 4.125 percent 2030 Treasury stock just mentioned. A data provider regularly used by Investor Chronicle suggests that its current redemption yield is 4.1% – truly wonderful, you might think. However, go to the Tradeweb website, which provides gilt prices to the UK debt management office, and the yield is minus 0.2%. This is a big difference. So which one is right?

Difficult to say since we do not know the inflation assumptions underlying the respective outputs. The solution may be to calculate our surrender yields, which isn’t difficult thanks to computer spreadsheets. The results are shown in Table 2 for the 0.125 percent Treasury 2026. This is a convenient example as the stock matures in 3.5 years, so only nine inputs are needed to get a result.

TABLE 2: CALCULATION OF REDEMPTION RETURNS
0 1/8% Indexed Treasury Gilt 2026
Cash Flows Amounts (£)
Date 3% inflation 5% inflation
Buy 04-November-22 -139.49 -139.49
Dividend 22-March-23 0.084 0.085
Dividend 22-September-23 0.086 0.087
Dividend 22-March-24 0.087 0.090
Dividend 22-September-24 0.088 0.092
Dividend 22-March-25 0.090 0.094
Dividend 22-September-25 0.091 0.096
Div’d & redemption 22-March-26 148,512 158.269
Return to maturity -1.10% -1.25%
Source: UK Debt Management Office, Investors’ Chronicle

The good news is that taking into account inflation of 3 percent or 5 percent yields yields close to those provided by Tradeweb for this bond. The bad news – of course – is that, even with today’s relatively low prices, the yield is still negative. It makes one think, why on earth would an investor invest capital in stocks like these expecting to make a loss of 3 and a half years down the line?

One answer might be because a small loss might be better than a larger loss that might be incurred elsewhere. Another possibility is that the result will be better than the spreadsheet suggests because, in fact, inflation rates higher than 3 percent or 5 percent are already embedded in dividends maturing in the next year or so, as the inflation is currently at 10 percent. cent. It also helps that index-linked gilt yields are still tied to the retail price index, the math of which produces a higher rate of inflation than the officially approved consumer price index.

Furthermore, prices may not be too far from generating acceptable real returns. If the Treasury price of 0.125 per cent in 2026 drops only 7 per cent to £ 130, this would produce real redemption yields of nearly 1 per cent. And this, it might be argued, falls within the margin of error in all investment calculations. It is in this spirit that Table 3 is shown, a roundup of the main indexed gilts in circulation. Just another bearish push and most will offer low-risk attractions, at least if you take them to maturity.

TABLE 3: ESTIMATE OF REFUND PAYMENTS
Indexed stocks Hypothesis of inflation Current price (£) Repayment yield (%) Outstanding (£ bn)
3.0% 5.0%
0 1/8% 2024 149.04 152.83 149.60 -3.33 21.6
2½% 2024 * 368.39 376.75 381.74 -2.23 22.4
0 1/8% 2026 148.42 158.17 139.49 -1.09 17.9
1¼% 2027 207.51 228.36 195.65 -0.56 25.1
0 1/8% 2028 147.31 164.36 127.53 -0.39 22.1
0 1/8% 2029 176.42 199.19 149.66 -0.31 22.4
4 1/8% 2030 * 318.00 364.99 341.49 -0.21 11.5
1¼% 2032 215.04 260.56 182.95 -0.17 23.2
0¾% 2034 209.11 259.93 161.75 0.00 21.6
2% 2035 * 282.68 353.78 243.95 0.08 16.8
0 1/8% 2036 202.12 264.50 133.02 0.13 18.4
1 1/8% 2037 267.66 357.07 196.23 0.16 22.2
0 5/8% 2040 267.85 373.71 170.46 0.23 22.4
0 1/8% 2041 215.75 309.15 121.03 0.23 15.3
0 5/8% 2042 295.39 433.86 175.84 0.23 20.3
0 1/8% 2044 269.28 405.76 138.27 0.27 22.3
0 1/8% 2046 268.65 420.69 129.37 0.28 18.0
0¾% 2047 350.21 566.32 185.19 0.30 19.4
0 1/8% 2048 270.47 443.45 120.90 0.28 14.8
0½% 2050 365.29 617.80 172.39 0.26 19.7
0¼% 2052 341.70 600.58 144.30 0.21 17.6
1¼% 2055 479.64 904.72 244.05 0.16 18.2
0 1/8% 2058 385.97 761.42 135.71 0.11 14.7
0 3/8% 2062 471.40 1,004.36 164.26 0.07 18.2
0 1/8% 2068 531.69 1,271.51 151.69 -0.08 17.4
Payment for nominal £ 100 of shares; * Indexing delay of 8 months (all other securities, 3 months). Source: UK Debt Management Office, Tradeweb

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