Bond Watch: time to look again at inflation-linked gilts?

In the wake of an energy supply crisis emanating from the Middle East, 2026 has seen a reassessment of disinflation prospects and a redrawing of interest rate projections.

The situation raises a conundrum, particularly for UK investors. As a net energy importer with less energy security than other regions, the UK is more sensitive to global supply-side inflation.

• Invest with ii: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

Alongside our unimpressive growth prospects, a limited degree of fiscal flexibility on the table and a tenuous political situation, the threat of stagflation is serious, and it is the topic of our latest On The Money podcast episode.

• How to navigate the big risk worrying the pros

Stagflation is a difficult environment for bond investors as inflation weakens the real value of coupon and principal payments, while weaker growth means central banks are unable to intervene by reducing interest rates.

Against this backdrop, index-linked bonds and, specifically for UK investors, inflation-linked gilts re-emerge as a portfolio consideration. 

This gilt type offers a potential hedge against inflation risk as the balance of risks shifts back towards inflation uncertainty rather than a straightforward continuation of disinflation.

What are inflation-linked gilts?

Inflation-linked gilts are UK government bonds, which are designed to protect investors from rising prices. Unlike conventional gilts, the value of the principal and the semi-annual interest payments are adjusted in line with inflation, historically using the Retail Price Index (RPI). For the majority of outstanding issues, changes in the RPI index are reflected three months after they are recorded, meaning investors are protected against inflation over time rather than immediately.

It is worth noting that UK government has also confirmed that RPI will be aligned with CPIH (the Consumer Prices Index including owner occupiers’ housing costs) from February 2030. As a result, all existing inflation-linked gilts will transition from being RPI-based to CPIH-based indexation from then onwards.

• How inflation-linked gilts work
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

For investors worried about the erosive impact of inflation on their savings, inflation-linked gilts can provide a useful form of protection within a diversified bond portfolio, but there are multiple factors to consider.

Risk vs reward

Broadly, it would be expected that inflation-linked gilts would underperform conventional gilts when inflation is falling or when investors become more optimistic about economic growth prospects.

Ultimately, a key driver of the performance of inflation-linked gilts is often not the absolute level of inflation, but whether inflation turns out to be higher or lower than markets had expected when the bonds were purchased. 

Such bonds tend to perform best during periods of unexpected or persistent inflation, as the inflation-linked uplift to principal and coupons can exceed what was already priced into conventional bond yields. In these environments, inflation-linked gilts can help preserve purchasing power and provide valuable diversification when conventional bonds come under pressure from rising inflation expectations.

Recently, despite their merits, inflation-linked gilts have endured a difficult few years. Rising interest rates initially caused significant capital losses across the sector, particularly among longer-dated bonds. Sensitivity to interest rate changes (known as ‘duration’) is a very important factor when it comes to performance. As was the case in 2022 when interest rates and yields rose to tackle rapid inflation, the negative price effects on more rate-sensitive, higher-duration inflation-linked gilts can actually offset the uplifts associated with the inflation-linking mechanism.

Selection therefore can be key because many inflation-linked gilts have long maturities (and thus more sensitivity to interest rates), with the duration of the FTSE Actuaries UK Index-Linked Gilts All Stocks Index being nearly 14 years versus 7.5 years for the FTSE Actuaries UK Conventional Gilts All Stocks Index.

• Fund Focus: how to navigate the bond turmoil
• Three corporate bonds make first move to appeal to DIY investors

However, when we look at the performance in recent years of short-dated inflation-linked gilts (with a duration of less than five years), they have tended to outperform their equivalent conventional gilts, doing so with decent risk-adjusted returns.

The current environment and role of inflation-linked gilts in a portfolio

While UK inflation has fallen significantly from its 2022 levels, the risks have not disappeared. We’ve seen recently how quickly domestic inflation can re-emerge and persist when energy markets are disrupted. Ongoing geopolitical tensions and uncertainty surrounding global energy supplies have the potential to generate fresh inflation shocks.

Investors can always assess the current relative value of inflation-linked giltsthrough break-even rates – representing the level of inflation at which an investor would be indifferent between holding an index-linked gilt and a conventional gilt of similar maturity. If future inflation exceeds that break-even rate, inflation-linked gilts should outperform conventional gilts with the reverse being true if inflation falls short.

Looking at 10-year maturities, the yield on an index-linked gilt is around 1.5% in real terms (reflecting the fact that inflation-linked gilts yields are quoted above inflation). In contrast, a conventional gilt of similar maturity offers a nominal yield of approximately 4.9%.

Current break-even inflation is therefore approximately 3.4% per annum, based on the difference between these yields. This compares with 12-month UK inflation currently running in the low-3% region, suggesting the market is pricing inflation to remain modestly above target over the medium to long term.

Therefore, for investors concerned that inflation risks remain underappreciated, inflation-linked gilts may therefore offer an attractive form of insurance against future inflation surprises. Importantly too, today’s higher real yields mean investors can lock in a positive return above inflation, making the asset class more attractive than it has been for much of the past decade.

Gaining exposure

The iShares £ Index-Lnkd Gilts ETF GBP Dist (LSE:INXG)offers low-cost passive exposure to inflation-linked gilts by tracking the BBG UK Government Inflation-Linked Bond Index. While this is pure and simple exposure with a yearly charge of just 0.1%, investors should note the duration of over 13 years given the nature of the index tracked. Therefore, this can make performance sensitive to interest rate changes despite the protection mechanism of the underlying bonds.

• How much do you need to secure a comfortable retirement?
• Fund Focus: the fund managers making contrarian bets

For investors seeking a broader, conservative approach to wealth preservation that is heavily invested in index linkers, Capital Gearing Ord (LSE:CGT) is a multi-asset option with currently 44% of the portfolio in index-linked government bonds. Given the conservative approach, this allocation is biased towards short-term issuances with an average duration of closer to five years across the UK and US linkers - Treasury Inflation-Protected Securities (TIPS).

Finally, investors may also consider investing directly in inflation-linked gilts. Investors may appreciate the exemption from capital gains tax when investing outside of an ISA and SIPP wrapper, as well as the ability to hold the bonds to maturity and reduce concerns regarding price changes. Although keep in mind that coupons are taxed as income if held outside a tax wrapper.

• Please note the funds highlighted are selected via the Highly Rated Funds Tool. For more investment ideas, visit The Highly Rated Funds - ii. The information provided should not be considered a personal recommendation.