Benstead on Bonds: how to beat the ‘single biggest’ wealth destroyer

Without doubt, inflation is the most corrosive long-run drag on investment portfolios. I’d go so far as to say that everything should be put in the context of inflation when looking at returns.

For example, during a very difficult 2022, most equity and bond portfolios lost money, but UK CPI inflation also peaked at 9.6% in October that year. So, if prices rose 10% and a portfolio dropped 10%, then there was a 20% wealth destruction effect.

During more typical inflation periods, say of between 2% and 3%, even returns above 5%, which may appear satisfactory, didn’t deliver much of a positive “real” return.

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Typically, countering the effects of inflation requires an allocation to equities. The reasons are simple: companies can raise prices and therefore protect profit margins, and can also grow via new products and services, which can deliver investors a share of a growing economy.

On the other hand, inflation is often described as “kryptonite” for bonds, as not only does it eat away at the real value of the fixed coupons they offer, but it can also lead to rising interest rates, which causes existing bonds to fall in value.

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But one type of fixed-income instrument can work well to protect you against inflation: inflation-linked gilts.

The UK government issues two types of gilts: conventional and index linked. Most gilts (around 75%) are conventional, meaning that the coupon remains fixed for the duration of the bond, as well as the principal value that’s returned when the gilt matures.

For the other 25% of gilts in issue, two semi-annual coupons and the final principal on maturity are adjusted depending on the level of Retail Price Index (RPI) inflation over the gilt’s life. This will change to the CPIH (the Consumer Prices Index including owner occupiers’ housing costs) from 2030 onwards.

The UK has the highest proportion of index-linked debt in the world, according to CG Asset Management, with 33 gilts in issue worth around £620 billion.

The yield you’ll find on an index-linked gilt is actually the “real” yield – of what you’ll get paid over the UK inflation rate if held to maturity.

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For example, the Debt Management Office recently issued the 1.75% Index-Linked Treasury Gilt 2038, which we allowed customers to participate in. This gilt matures in 13 years, promising a 1.75% annualised return above the inflation rate over that period.

These index-linked gilts must be traded on secondary markets over the phone at ii – but at the usual £3.99 dealing fee – as the “index ratio” must be calculated to adjust the price of the gilt in order to compensate the seller for any accrued interest. This is known as the “dirty” price, as opposed to the “clean” price that is quoted on exchanges.

There are plenty of inflation-linked gilts available to meet different investment horizons, as shown in the table below. Generally speaking, the longer the maturity date, the higher the yield.

Index-linked gilts in issue: March 2025

Source: Tradeweb, 5 March 2025. Debt Management Office note: “Clean Price” does not include any accrued interest. “Dirty Price” is including accrued interest.

The power of inflation-linked

Inflation-linked gilts are appealing to many defensive investors who are worried about rising or volatile inflation, but still want the security of fixed income in portfolios.

One of those is Chris Clothier, co-manager of Capital Gearing Ord (LSE:CGT) investment trust, who says inflation-linked bonds are the “mirror image” of equities.

“That’s to say they tend to do best when equities do worse and vice versa. That makes them a really useful portfolio hedge for equities,” he says.

Another reason Clothier likes them is that inflation is what he calls the “single biggest threat to investors’ wealth” and they offer protection against that.

The final reason he likes them is that over the past 25 years, he calculates that inflation-linked bonds have pretty consistently outperformed their conventional counterparts.

“We think that that is likely to continue. Finally, of course, we just think that inflation is likely to be higher in the future than it has been in the past,” he says.

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Their house view is that inflation, on average, is going to be above central banks’ target most of the time over the coming 15 to 20 years.

Another proponent of index-linked bonds is Alec Cutler, manager of Orbis OEIC Global Balanced fund.

Cutler says conventional bonds are too expensive versus their inflation-adjusted counterparts.

He looks at US government bonds, for example, where the 10-year US Treasury yields 4.5% currently.

Cutler says: “We think inflation is going to be 4.5%. So, you’re actually earning nothing and you’re just treading water. Whereas a 10-year inflation-protected bond yields 2% real. So, you get 2%-plus inflation twice a year, you get inflation plus your real interest rate. So, if inflation winds up being 4.5% and we have 2% real on top, we’re getting a 6.5% return risk-free.”

Their strategy is to own a range of inflation-linked US government bonds in a “ladder” of maturities, meaning that he owns a portfolio of inflation-linked bonds maturing at different times.

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Finally, Sebastian Lyon and Charlotte Yonge, managers at Personal Assets Ord (LSE:PNL), argue that inflation-linked bonds are well-placed to thrive in a period of “regime change” in markets.

They say that central banks will struggle to get inflation back to targets, government spending and debt will continue to rise, and the interest burden will therefore become a greater and greater part of government spending.

On top of that, globalisation is in reverse and cannot be relied on to bring inflation down, and the world is again at war, leading to greater uncertainty and inflationary pressures, according to the fund managers.

To invest in this environment, they are sticking with shorter-duration bonds, where prices will move less as interest rates change.

What about the risks with index-linked?

While index-linked bonds give investors a useful inflation-linked return if held to maturity, the price of the bonds can swing dramatically before they mature.

Index-linked bonds are actively traded on secondary markets, meaning that investors can choose to pay more for a bond than its issue price or less, depending on market conditions. Interest rates are the most important factor when pricing bonds.

When inflation begins to increase, central banks tend to raise interest rates to try and cool inflation. This is what happened in 2022.

This is bad news for the price of bonds as investors are no longer getting the best rate, and inflation erodes the value of returns. Investors sell bonds, causing prices to fall and yields to rise.

Because of high demand from big financial institutions, UK inflation-linked bonds typically take a long time to mature, often more than 20 years. They therefore have high “duration” - the sensitivity of a bond, or bond fund, to any change in interest rates. The higher the duration, the more sensitive the bond is to a movement in rates.

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This can lead to bigger price drops when interest rates rise, but also big jumps in value when they fall.

The result is that index-linked gilts do not necessarily offer protection against inflation over shorter periods as the prices of the bonds could fall dramatically.

However, investors who buy index-linked bonds directly and hold them to maturity do not have to worry about rising and falling bond prices and can simply enjoy inflation-adjusted returns.

Owning index-linked bonds via a fund does not have the same advantage, as the portfolio never matures and is marked to market prices daily, meaning you are not locking in a return.