The index-linked puzzle

Why do investors ignore a guaranteed real return of 3.5 per cent?
Why don't more people buy index-linked gilts? The question has long been a puzzle. Now it seems more pertinent than ever. All the latest economic indicators suggest that inflationary expectations are starting to rise again.

The Bank of England is already pressing openly for higher interest rates, and the money markets are setting the price of gilts and interest rate futures at levels which imply that higher rates are on the cards for next year. Unemployment is falling faster than expected, fuelling expectations that the economy is approaching the point where it cannot grow much further without inflation reviving.

On top of that we have all the risks of a pre-election period, with consumer spending booming, tax cuts in the offing, and unaffordable rises in public spending again a real possibility. Only the strength of sterling, this month's favourite currency, is currently acting to dampen inflationary expectations.

Put all this together and it is hard to avoid the conclusion that the risks of higher inflation are indeed rising. This ought to be an environment in which index-linked gilts prosper.

And so, to a degree, they have been. The real yield on long term index- linked gilts has this year fallen below 3.5 per cent, down from its peak of 4.5 per cent five years ago.

For the last three years the big investment institutions have gradually been increasing their holdings of index-linked gilts. As a result, prices of index-linked gilts are now trading close to their year's highs.

Yet most of this revival has passed the individual investor by. Most individuals, by and large, do not buy index-linked gilts, preferring to put their money either into building societies, equities or into insurance products of various kinds.

Conventional gilts are traditionally not very popular with ordinary investors either, and it may be that index-linked are simply too complicated to catch on. Certainly, most people seem blissfully unaware that they exist, let alone how they work.

Why should this be so? Cynics may say it is because, unlike unit trusts, nobody has a vested interest in selling or advertising them. A simpler reason may be that investors are simply not accustomed to think in terms of real - rather than nominal - returns.

It is much easier to think in terms of actual cash returns rather than on the purchasing power which that cash represents. A 3.5 per cent "real" return does not sound either very meaningful or very impressive. Yet it is the equivalent of 6.5 per cent in money terms (adding the current inflation rate of 3.0 per cent).

The great attraction of an index-linked gilt is that, if you hold it until its maturity date, both the income you receive and the capital you have invested are guaranteed to be fully protected against inflation.

No other investment offers such an effective guarantee of both income and principal. As the guarantee comes from the Government, the money is even more secure than it would be in a bank or building society. The guaranteed return - 3.5 per cent in real terms - is at least double what you currently get on a building society deposit account.

Add to that the other advantages of buying any kind of gilt - you can buy them direct or at a post office for the tiniest of commissions, with no brokers or advisers to pay - and their neglect seems bizarre.

A 3.5 per cent real return may not sound like much, but given how risk- averse many investors are, it is by no means unattractive. Not for nothing are index-linked gilts are dubbed "the ultimate defensive investment".

As Stephen Lofthouse points out in an excellent new book about personal investing*, it may be that investors have been misled by the high returns which have been available on shares in the 1980s into projecting them forward indefinitely. It is true that returns from index-linked gilts have lagged well behind both shares and conventional gifts in the last 10 years.

The annual total return from an index-linked gilt in the ten years to 1995, for example, was 7.9 per cent, against 14.2 per cent for conventional gilts and 18.6 per cent for equities.

But this is only part of the story. Investment is about risk as well as reward. It so happens that the last 10 years have been characterised by conditions - falling interest rates and inflation, rising corporate profitability - which have been uniquely favourable to shares, broadly kind to conventional gilts and least suited to index-linked gilts.

Yet the one certainty is that neither shares nor conventional gilts can sustain the kind of high real returns recently achieved forever. It is a historical aberration which must one day come to an end.

As Lofthouse points out, the long-term real return on equities is 7-8 per cent. But that is before taking account of charges and costs.

If you hold all your shares through a unit trust or investment trust, the effective real return after taking account of costs and management charges may falls to something nearer 4.0-5.0 per cent per annum.

For that you have to take on all the risks of the equity market. For any long term investor, starting out today, the 3.5 per cent real return on index-linked gilts looks very attractive by comparison, given that it comes entirely risk-free and at a time when inflationary risks appear to be reviving.

Of course nobody should put all their money into index-linked. They will never produce fireworks. But the case for making them part of any sensible investment portfolio looks stronger today than for a long time.

And if inflation does revive, and real yields decline further, you will have the chance to make capital gains as well.

*'How to Fix Your Finances' John Wiley & Sons.