Everyone, through their recent lived experience, understands the significant uplift in prices we have seen in recent years driven the double whammy of the pandemic (and subsequent policy response) and the war in Ukraine (and the consequent energy shock). However, the impact on returns for cash and cash-like investments is often under appreciated. Below, we walk you through the return of two UK government bonds (gilts), one nominal and one index-linked that are both approaching redemption, starting at the beginning of 2019, in both nominal and real returns.

The specific gilts used are: UK Gilt 1% 22/4/24 and UK Inflation-Linked Gilt 0.125% 22/3/24 These have been selected as they have almost the same maturity and have very low coupons. Hence the numbers quoted below are approximations based on price return (rather than total return including coupon payments) that are broadly comparable to illustrate the point, rather than exact calculations.

First the nominal gilt. The chart below shows the yield on this gilt from 01/01/19 was 1%. In the years that followed, inflation jumped and yields rose to around 5%, as the Bank of England increased the base rate and the gilt approached maturity.

The chart below shows the price return, where the gilt started at around 100, fell as short-term rates rose, and is now virtually back to 100 as it approaches maturity. The 1% annual yield all came from the coupon but despite all the price swings, the Gilt delivered the 1% return it mathematically had to when purchased.

However, over the period with the high rates of inflation, the price level increased around 33% based upon the RPI.

Hence in real terms this nominal gilt lost around 21% over the period. The chart below shows the price return to which we add 5% as an approximation for the coupons over the period. Not great for a “risk free” investment.

UK Nominal Gilt Real Price Return 2019-2024

Moving to the index-linked bond, looking back to January 2019 the real yield on this bond was a very unappealing -2.2%. This was a reflection of the deeply negative real yields that persisted all across the UK index-linked curve.

UK Inflation-Linked Gilt 0.125% 22/3/24 Real Yield 2019-2024

Buying this bond meant that you were guaranteed to have a return over the period of 12% less than inflation, which is indeed what you got.

However, because the coupon and principal are uplifted by the RPI, the nominal return on this bond was 17%, handily beating the nominal bond. This is because the actual realised inflation turned out to be much higher than the breakeven inflation priced into the bonds at the outset of our analysis.

Going through the actual mechanics of what played out during an inflationary shock and working out what that means for nominal and real returns in the risk-free sovereign fixed income markets is a useful exercise when thinking about the future. Key Takeaways:

While a 1% nominal return may optically feel better than a -2.2% real return it may not be if inflation comes in higher than is priced into markets. In the UK, markets see the RPI at between 3% and 3.5% across all tenors, short and long.
The massive shift higher in the curve we have seen in the last two years means that prospective returns from gilts are materially better as shown in the chart below.
Long duration indexed linked bonds can be exceptionally volatile, however with +1.4% real yields over 20-30 years, these assets can provide a great anchor to portfolios. Many factors affect the level of real yields, and they can certainly go higher, however there is a level at which they become more attractive than almost all other assets on a risk adjusted basis. Investors should have some exposure and add on any material price weakness.
They are an excellent hedge should the events of the early 2020s prove not to be a transitory episode in history.

Gilty Secrets

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