Inflation-linked gilts: why some no longer offer full protection

Inflation is a key hurdle for investors to overcome as they seek to grow wealth over the long term.  

As ever, diversification can help both smooth out volatility and provide a portfolio with ample opportunity to rise in real terms.

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Typically, countering the effects of inflation requires having a good portion of a portfolio in shares, due to their status as a growth asset and certain companies’ ability to pass on price rises.

Bonds, in contrast, generally serve as the defenders in a portfolio, helping to guard against stock market volatility.

Some bonds can also potentially help shield against the prospect of sticky or rising inflation.

While inflation increases are typically bad news for conventional bonds (as it makes the future fixed coupon payments on the bond less valuable), inflation-linked bonds, a type of gilt, provide a route to gaining income that rises in line with price increases.

For this gilt type, two semi-annual coupons and the final principal on maturity are adjusted higher or lower to account for the change in 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.

For index-linked gilts the “real yield” reflects what investors will receive over the UK inflation rate if held to maturity.

However, bear in mind that the real yield can turn negative. When this occurs, investors do not receive the full inflation benefits. This has recently played out for T27, a short-term inflation-linked gilt maturing in November 2027. The bond’s price has risen in response to conflict in the Middle East, amid expectations that inflation will rise in the short term following the big jump in the oil price.

As a result, its yield has fallen, resulting in it turning negative (-0.47% to 9 March, according to Tradeweb). Whereas a month ago (on 9 February), it was offering a positive yield of 0.11%.

Therefore, investors looking for positive yields above inflation following the maturity of TR26 on 22 March 2026, will need to set their sights on bonds with longer maturities. As of 9 March, T28 (maturing in August 2028) is showing a negative yield of -0.13%, but T29 (March 2029) is in positive territory, yielding 0.21%.

A month ago, T28 had a yield of 0.27% and T29 had a yield of 0.56%.

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Bonds with longer lifespans are offering higher real yields. For example, TG36 (maturing in November 2036) has a yield of 1.39%. Its yield has also narrowed over the past month, but not as much as the shorter-dated inflation-linked gilts. This is due to the fact that the market is not pricing in inflation being higher than expected in 10 years’ time.

Bear in mind that a potential drawback for bonds with a long lifespan is that the price of the bonds can swing dramatically before they mature. This is due to them having a high “duration”, meaning such bonds are more sensitive to changes in interest rates.

This can lead to bigger price drops when interest rates rise - which could more than offset any increase in principal and coupon payments - but also big jumps in value when they fall. This is important to weigh up for those intending to sell rather than hold until the gilts’ maturity.

Elsewhere, investors could consider regular gilts that do not offer inflation linkage. Some regular gilts are offering coupons ahead of UK inflation, such as TR30 (4.75% Treasury Gilt 2030) and TR34 (4.5% Treasury Gilt 2034).

In addition, money market funds typically have yields that are close to UK interest rates. Such funds are yielding ahead of inflation at around 3.75%. Such funds own a diversified basket of safe bonds that are due to mature soon, normally within just a couple of months, meaning that investors can earn an income on their cash with minimal risk.

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Among the options are: Royal London Short Term Money Market, L&G Cash Trust, Fidelity Cash, BlackRock Cash, Vanguard Sterling Short Term Money Market and abrdn Sterling Money Market. 

In a nutshell, money market funds are designed to be low-risk, straightforward products that behave in a cash-like manner. Investors often use them to park cash balances for a short period while deciding where to invest, or to guard against periods of stock market volatility.