Why Britain’s best defensive trusts own so many inflation-linked bonds

Despite crashing in value this year, cautious investors still think index-linked bonds can protect them.

Look under the bonnet of “capital preservation” investment trusts, one of this year’s top sectors, and one thing will stand out: they all allocate a large percentage of their investments to inflation-linked bonds.

Ruffer Investment Company has about 30% invested in index-linked bonds, Capital Gearing has 34% and Personal Assets has 37%.  

The trio have protected capital well this year. Ruffer has returned 4%, Personal Assets is down 5.5% and Capital Gearing is down 6%. This is compared with a total return, in sterling terms, of -9% for the MSCI All-Country World index.

• Explore our: Top Investment Trusts  | Sustainable Funds List | Transferring an Investment Account

But index-linked bonds have been one of the worst-performing investments this year, with a basket of them from BlackRock (the iShares Index Linked Gilts Ucits ETF) dropping 46% in value, which includes the income return.

Index-linked gilts (issued by the UK government) differ from conventional gilts in that both the semi-annual coupon payments and the principal payment are adjusted in line with movements in RPI, an inflation measure that also includes mortgage costs alongside a basket of commonly bought goods.

As inflation rises, payments to investors also rise – in theory this is perfect for investors looking for income that can keep up with inflation and who are looking to avoid the negative real yields from normal bonds.

• Ask ii: can I get a yield of 4% or more from bonds like I can from equities?
• Ask ii: why is this inflation-linked bond fund losing money?

However, bond prices are at the whim of markets, which is why they have lost money this year. When inflation begins to increase, central banks tend to raise interest rates, as they are doing now. This is bad news for the prices of bonds as investors are no longer getting the best rate and inflation erodes the value of returns. They sell bonds, causing prices to fall and yields to rise.

Last year, inflation was picking up but there was little indication that rates would rise as central banks thought inflation would be “transitory”. This made index-linked bonds one of the best types of bonds to hold.

However, now that rates are rising sharply, this is impacting the price of all bonds. However, index-linked ones are hit particularly hard. Because of high demand from big financial institutions, UK inflation-linked bonds typically take a long time to mature, often more than 20 years. Bonds with long lifespans have long “durations”, which are most sensitive to increases in interest rates.

Duration refers to the sensitivity of a bond, or bond fund, to any change in interest rates. For every 1% rise in interest rates, a bond’s price will fall by about 1% for every year of duration.  

Nevertheless, capital preservation trusts are still heavily invested in inflation-linked bonds. We asked the managers why.

• Active versus passive funds: a beginner’s guide
• Peter Spiller: the biggest risks for markets in 2022

Hedging interest rate risk

Ian Rees, investment director at Ruffer, says inflation-linked bond prices are generally driven not by the current rate of inflation but by investors’ expectations of future levels. In addition, they are vulnerable to “duration” risk, he says, which is when rising interest rates could drive down bond prices.

Rees explains: “We think inflation is likely to be volatile for some time, with sharp falls and rises as the economy adjusts to the post-pandemic realities. In that case, these inflation hedges would tend to lose value in the phases when inflation is declining, but timing such fluctuations is notoriously difficult.”

To eliminate much of the “duration” risk, Ruffer Investment Company uses financial contracts known as derivatives. Ruffer uses “interest rate payer swaptions”, which offer protection against rising bond yields.   

• Why investors are retreating to passive funds as markets fall
• Terry Smith continues tech buying spree as shares drop

Rees adds: “Of course, we have to pay for these derivatives, and this can act as a drag on performance, particularly when mainstream assets are rising. But that is a price we are willing to pay for assets with a negative correlation to our equity holdings in the event of a severe market downturn.”

Ruffer also holds plenty of cash, about 6% of the portfolio, even though its purchasing power is eroded during periods of high inflation.

Rees said: “We see it as a protection against more severe declines in other assets – the real value falls in bonds and equities can be much more severe and, crucially, as a reserve we can use to take advantage of any opportunities arising from the volatility in equity and bond markets.”

Inflation-linked gilts good value again

Capital Gearing Trust is also a big backer of index-linked bonds, but has not used derivatives to protect its portfolio against rising interest rates.

Instead, the trust, which has been managed by Peter Spiller for 40 years, preferred to own international index-linked bonds, such as those from the US and Canada.

Alastair Laing, a manager on the trust, says that going international protected the portfolio from the worst of the index-linked bond crash due to the strength of the US dollar and due to such overseas bonds being better value.

He said: “We have made money in sterling terms this year due to a weak pound and strong dollar. We avoid index-linked gilts because they were too expensive, guaranteeing negative returns after inflation.”

But now that investors are selling index-linked bonds, sending yields higher, Laing is becoming more interested in the UK market.

He says that a 10-year index-linked gilt now offers 2% returns above CPI inflation, or about 1% above RPI inflation.

“This is a huge change. Real yields were negative before because bonds prices were too high,” Laing said.

• Seven biases that could be hitting your investment returns
• Ian Cowie: I’m in danger of falling in love with my first 10-bagger

How good value is this though? Laing says that in the 1980s investors could lock in a 4% real yield with an inflation-linked bond, but in today’s uncertain environment 2% above the inflation rate is very attractive.

He said: “In a highly uncertain environment, having a set return risk free above inflation is a better deal than in a secure environment. No one knows the exact outlook, but we think inflation will be higher for longer, and central banks may even change their inflation targets.

“If you hold these bonds to maturity then you don’t need to worry about volatility and you can just collect your 2% real yield tax free, so long as it’s held inside an ISA or SIPP.”

Elsewhere, in its latest quarterly update to investors, Personal Assets Trust manager Sebastian Lyon, also sang the praises of index-linked bonds, but prefers the US market over the British.

He said: “We remain convinced that we will make good, if not great, returns from our US Treasury inflation-protected Securities (TIPS), which are today offering a real return of around 1% a year. Hardly mouth-watering, admittedly, but we expect over the coming years a return in excess of the level of inflation will be gratefully received and perhaps even coveted.”

The trust has been adding to its US index-linked bond portfolio this year. Lyon said: “We used the weakness in index-linked during the first half of the year to increase the duration of the portfolio’s TIPS.

“With this exception, we were not especially active in the first half. We remain of the opinion that equity valuations are yet to reach appealing levels. If we are right and the world has changed, there is a greater adjustment to be made as valuations revert to the old normal.”