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.

Life and Style
Small winemakers say the restriction makes it hard to sell overseas
food + drink
Arts and Entertainment
A comedy show alumni who has gone on to be a big star, Jon Stewart
tvRival television sketch shows vie for influential alumni
Arts and Entertainment
Carrie Hope Fletcher
booksFirst video bloggers conquered YouTube. Now they want us to buy their books
News
Clare Balding
peopleClare Balding on how women's football is shaking up sport
PROMOTED VIDEO
Have you tried new the Independent Digital Edition apps?
Arts and Entertainment
Damien Hirst
artCoalition's anti-culture policy and cuts in local authority spending to blame, says academic
Sport
premier leagueMatch report: Arsenal 1 Man United 2
Arts and Entertainment
Kirk Cameron is begging his Facebook fans to give him positive reviews
film
News
i100
Sport
Jonny May scores for England
rugby unionEngland 28 Samoa 9: Wing scores twice to help England record their first win in six
Life and Style
fashionThe Christmas jumper is in fashion, but should you wear your religion on your sleeve?
Arts and Entertainment
Jason goes on a special mission for the queen
tvReview: Everyone loves a CGI Cyclops and the BBC's Saturday night charmer is getting epic
Arts and Entertainment
Jerry Hall (Hand out press photograph provided by jackstanley@theambassadors.com)
theatre
Sport
Tony Bellew (left) and Nathan Cleverly clash at the Echo Arena in Liverpool
boxingLate surge sees Liverpudlian move into world title contention
Voices
Neil Findlay
voicesThe vilification of the potential Scottish Labour leader Neil Findlay shows how one-note politics is today, says DJ Taylor
Life and Style
food + drinkMeat-free recipes and food scandals help one growing sector
Finacial products from our partners
Property search
Sarah Bibby and Robert Allinson, with their children Charlotte and Ethan, confronted the ‘difficult’ questions’ posed by making a will

Simon Read: There may be trouble ahead for cohabiting couples who don’t make a will

Your children have it all, your partner gets nothing

Halfords is gearing up for Christmas

Bargain Hunter: Find the deals that have real value beneath the Black Friday hype

Halfords is gearing up for Christmas

Fields of dreams: venture capital trusts help young companies to grow, potentially delivering big returns for investors

Mark Dampier: You take a chance but VCTs have sorted the wheat from the chaff

Fields of dreams: venture capital trusts help young companies to grow, potentially delivering big returns for investors 

The FCA has imposed £1.1bn in fines on five banks over forex trading practices

Simon Read: Catch 22 for borrowers who are turned down by banks

There are many reasons for people to turn to high-cost credit, but being turned down by their banks for a loan is one

The battle between the banks to attract more current account customers moved up a level this week when Yorkshire Bank (and Clydesdale Bank) launched a market- leading £150 switching incentive.

Money Insider: Would £150 make you switch banks?

The £150 incentive from Yorkshire and Clydesdale runs from now until 28 February next year, but you must use the official Current Account Switching Service (CASS) and close your existing account to qualify

The short slope that takes women all the way down to living on the streets

For the rising number of homeless women, the struggle is compounded by health problems and by losing their children

If you’ve got a card in your wallet that charges a low standard interest rate, there’s less financial impact if you can’t repay your full statement balance.

Money Insider: Save money with the right credit card

Research from Sainsbury’s Bank Credit Cards this week revealed that 15 per cent of people making a large purchase on their plastic didn’t use one with 0 per cent interest on purchases

Last week was hangover time, when Stock Spirits, a vodka producer, distilled a profit warning that sent its shares crashing more than 25 per cent. (image: Rex Features)

No Pain No Gain: Vodka causes a hangover as shares in Stock Spirits slump

Last week was hangover time, when Stock Spirits, a vodka producer, distilled a profit warning that sent its shares crashing more than 25 per cent

Investment melting pot: the price of gold may have fallen but Artemis Strategic Assets believes its value cannot be debased

Mark Dampier: Strong returns can be found if you go the opposite way to the crowds

Investment melting pot: the price of gold may have fallen but Artemis Strategic Assets believes its value cannot be debased

The Bank of England announced that interest rates will stay at 0.5 per cent

Simon Read: Banks can’t blame the economy for their low rates

Interest rates are currently as low as 0.1 per cent

The schemes work by using collective power to negotiate better deals with gas and electricity suppliers

Simon Read: Don’t blow a fuse with your energy supplier, just switch

The energy watchdog Ofgem has slammed Scottish Power, while Citizens Advice reports a string of complaints about it

John Lush from Hampshire got into debt with payday lenders and had the help of a debt management charity to clear the £20,000 he owed

Simon Read: The only place for debt is out in the open, don't be afraid to ask for advice

John Lush from Hampshire got into debt with payday lenders and had the help of a debt management adviser to clear the £20,000 he owed

Seven Families campaign aims to raise awareness of financial damage caused by illness or disability

The campaign is handing financial help to seven families for a year, along with support and advice in how to get their careers back on track
The 10th birthday of broadband in Britain was marked with a projection in 2010. But the infrastructure is still being rolled out

Families pay the price of superfast broadband

Bills are going up for households around the UK as providers invest in better infrastructure. Emma Lunn explains why - and what to do

How to cut the cost of car insurance: A five-step guide to getting a better deal

Premiums are on the rise again but motorists don't have to take a back seat on the price of their cover, says Rob Griffin
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Reach Volunteering: Trustee – PR& Marketing, Social Care, Commercial skills

    Voluntary Only - Expenses Reimbursed: Reach Volunteering: Age Concern Slough a...

    Reach Volunteering: Charity Treasurer

    Voluntary Only - Expenses Reimbursed: Reach Volunteering: Crossroads Care is s...

    SThree: Trainee Recruitment Consultant - Soho

    £20000 - £25000 per annum + OTE £35,000: SThree: We consistently strive to be ...

    Ampersand Consulting LLP: Markit EDM (CADIS) Developer

    £50000 - £90000 per annum + benefits: Ampersand Consulting LLP: Markit EDM (CA...

    Day In a Page

    Mau Mau uprising: Kenyans still waiting for justice join class action over Britain's role in the emergency

    Kenyans still waiting for justice over Mau Mau uprising

    Thousands join class action over Britain's role in the emergency
    Isis in Iraq: The trauma of the last six months has overwhelmed the remaining Christians in the country

    The last Christians in Iraq

    After 2,000 years, a community will try anything – including pretending to convert to Islam – to avoid losing everything, says Patrick Cockburn
    Black Friday: Helpful discounts for Christmas shoppers, or cynical marketing by desperate retailers?

    Helpful discounts for Christmas shoppers, or cynical marketing by desperate retailers?

    Britain braced for Black Friday
    Bill Cosby's persona goes from America's dad to date-rape drugs

    From America's dad to date-rape drugs

    Stories of Bill Cosby's alleged sexual assaults may have circulated widely in Hollywood, but they came as a shock to fans, says Rupert Cornwell
    Clare Balding: 'Women's sport is kicking off at last'

    Clare Balding: 'Women's sport is kicking off at last'

    As fans flock to see England women's Wembley debut against Germany, the TV presenter on an exciting 'sea change'
    Oh come, all ye multi-faithful: The Christmas jumper is in fashion, but should you wear your religion on your sleeve?

    Oh come, all ye multi-faithful

    The Christmas jumper is in fashion, but should you wear your religion on your sleeve?
    Dr Charles Heatley: The GP off to do battle in the war against Ebola

    The GP off to do battle in the war against Ebola

    Dr Charles Heatley on joining the NHS volunteers' team bound for Sierra Leone
    Flogging vlogging: First video bloggers conquered YouTube. Now they want us to buy their books

    Flogging vlogging

    First video bloggers conquered YouTube. Now they want us to buy their books
    Saturday Night Live vs The Daily Show: US channels wage comedy star wars

    Saturday Night Live vs The Daily Show

    US channels wage comedy star wars
    When is a wine made in Piedmont not a Piemonte wine? When EU rules make Italian vineyards invisible

    When is a wine made in Piedmont not a Piemonte wine?

    When EU rules make Italian vineyards invisible
    Look what's mushrooming now! Meat-free recipes and food scandals help one growing sector

    Look what's mushrooming now!

    Meat-free recipes and food scandals help one growing sector
    Neil Findlay is more a pink shrimp than a red firebrand

    More a pink shrimp than a red firebrand

    The vilification of the potential Scottish Labour leader Neil Findlay shows how one-note politics is today, says DJ Taylor
    Bill Granger recipes: Tenderstem broccoli omelette; Fried eggs with Mexican-style tomato and chilli sauce; Pan-fried cavolo nero with soft-boiled egg

    Oeuf quake

    Bill Granger's cracking egg recipes
    Terry Venables: Wayne Rooney is roaring again and the world knows that England are back

    Terry Venables column

    Wayne Rooney is roaring again and the world knows that England are back
    Michael Calvin: Abject leadership is allowing football’s age-old sores to fester

    Abject leadership is allowing football’s age-old sores to fester

    Those at the top are allowing the same issues to go unchallenged, says Michael Calvin