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.

News
Denny Miller in 1959 remake of Tarzan, the Ape Man
people
Arts and Entertainment
Cheryl despairs during the arena auditions
tvX Factor review: Drama as Cheryl and Simon spar over girl band

News
Piers Morgan tells Scots they might not have to suffer living on the same island as him if they vote ‘No’ to Scottish Independence
news
News
i100Exclusive interview with the British analyst who helped expose Bashar al-Assad's use of Sarin gas
PROMOTED VIDEO
Have you tried new the Independent Digital Edition apps?
Sport
Angel Di Maria celebrates his first goal for Manchester United against QPR
Football4-0 victory is team's first win under new manager Louis van Gaal
Arts and Entertainment
art
News
newsIn short, yes
Arts and Entertainment
Rob James-Collier, who plays under-butler Thomas Barrow, admitted to suffering sleepless nights over the Series 5 script
tv'Thomas comes right up to the abyss', says the actor
Arts and Entertainment
Calvin Harris claimed the top spot in this week's single charts
music
Sport
BoxingVideo: The incident happened in the very same ring as Tyson-Holyfield II 17 years ago
News
Groundskeeper Willie has backed Scottish independence in a new video
people
Arts and Entertainment
The Doctor poses the question of whether we are every truly alone in 'Listen'
tvReview: Possibly Steven Moffat's most terrifying episode to date
News
i100
Life and Style
Cara Delevigne at the TopShop Unique show during London Fashion Week
fashion
News
The life-sized tribute to Amy Winehouse was designed by Scott Eaton and was erected at the Stables Market in Camden
peopleBut quite what the singer would have made of her new statue...
Sport
England's Andy Sullivan poses with his trophy and an astronaut after winning a trip to space
sport
News
peopleThe actress has agreed to host the Met Gala Ball - but not until 2015
Finacial products from our partners
Property search

Leaving money to charity in your will could help reduce the tax bill for your loved ones

Next week has been designated "remember a charity in your will week", to put the focus squarely on the subject

Two million first-time buyers are locked out

The drought in lending to people with low deposits has created legions of frustrated buyers, writes Emma Lunn
Money is slipping through our fingers: the UK is falling behind other countries in the amount we put away

How to save money: UK is crashing down the European league table for putting money away

The UK has slipped to 11th in the latest European league table of savers. Rob Griffin checks out the best options

Energy firms found guilty of bad practice could have licences revoked under Labour government

Caroline Flint, the shadow energy secretary, says a Labour government would create a new energy regulator

A student's guide to financial survival: You don't have to drown in debt at university

Fresh from A-level delight, the moment does not have to be soured by students resigning themselves to thousands of pounds worth of debt in three years' time. Rob Griffin sees how to pass the university challenge

'Dismal' eurozone data sparks concerns

European Central Bank chief Mario Draghi is under pressure to launch promised stimulus before the EU slides further
Love but not marriage: property is one area where cohabiting couples are in danger of losing out

How couples can protect their financial interests when cohabiting

People who simply live together cannot assume they have the same rights to each other's assets as spouses or civil partners. Michelle McGagh sees how they can protect their financial interests

India could be jewel in the crown for investors

With a new government and an ambitious prime minister, the country offers the prospect of strong returns. But there may be hiccups ahead, warns Simon Read
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

    SQL Developer - Watford/NW London - £280 - £320 p/d - 6 months

    £280 - £320 per day: Ashdown Group: The Ashdown Group have been engaged by a l...

    Senior BA - Insurance **URGENT**

    £400 - £450 Per Day: Clearwater People Solutions Ltd: **URGENT CONTRACT ROLE**...

    Training Coordinator / Resource Planner - City, London

    £35000 - £38000 per annum + Benefits: Ashdown Group: Training Coordinator / Pl...

    Data Governance Manager (Solvency II) – Contract – Up to £450 daily rate, 6 month (may go Permanent)

    £400 - £450 Per Day: Clearwater People Solutions Ltd: We are currently looking...

    Day In a Page

    These Iranian-controlled Shia militias used to specialise in killing American soldiers. Now they are fighting Isis, backed up by US airstrikes

    Widespread fear of Isis is producing strange bedfellows

    Iranian-controlled Shia militias that used to kill American soldiers are now fighting Isis, helped by US airstrikes
    Topshop goes part Athena poster, part last spring Prada

    Topshop goes part Athena poster, part last spring Prada

    Shoppers don't come to Topshop for the unique
    How to make a Lego masterpiece

    How to make a Lego masterpiece

    Toy breaks out of the nursery and heads for the gallery
    Meet the ‘Endies’ – city dwellers who are too poor to have fun

    Meet the ‘Endies’ – city dwellers who are too poor to have fun

    Urbanites are cursed with an acronym pointing to Employed but No Disposable Income or Savings
    Paisley’s decision to make peace with IRA enemies might remind the Arabs of Sadat

    Ian Paisley’s decision to make peace with his IRA enemies

    His Save Ulster from Sodomy campaign would surely have been supported by many a Sunni imam
    'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

    'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

    Exclusive extract from Janis Winehouse's poignant new memoir
    Is this the role to win Cumberbatch an Oscar?

    Is this the role to win Cumberbatch an Oscar?

    The Imitation Game, film review
    England and Roy Hodgson take a joint step towards redemption in Basel

    England and Hodgson take a joint step towards redemption

    Welbeck double puts England on the road to Euro 2016
    Relatives fight over Vivian Maier’s rare photos

    Relatives fight over Vivian Maier’s rare photos

    Pictures removed from public view as courts decide ownership
    ‘Fashion has to be fun. It’s a big business, not a cure for cancer’

    ‘Fashion has to be fun. It’s a big business, not a cure for cancer’

    Donatella Versace at New York Fashion Week
    The fall of Rome? Cash-strapped Italy accused of selling its soul to the highest bidder

    The fall of Rome?

    Italy's fears that corporate-sponsored restoration projects will lead to the Disneyfication of its cultural heritage
    Glasgow girl made good

    Glasgow girl made good

    Kelly Macdonald was a waitress when she made Trainspotting. Now she’s taking Manhattan
    Sequins ahoy as Strictly Come Dancing takes to the floor once more

    Sequins ahoy as Strictly takes to the floor once more

    Judy Murray, Frankie Bridge and co paired with dance partners
    Wearable trainers and other sporty looks

    Wearable trainers and other sporty looks

    Alexander Wang pumps it up at New York Fashion Week
    The landscape of my imagination

    The landscape of my imagination

    Author Kate Mosse on the place that taught her to tell stories