Why Are Index Linked Funds Falling Despite High Inflation?

Why are my index linked UK gilt funds and global index linked bonds falling despite high inflation?  Is this good or bad for my investments?  Should I switch out of my index linked funds?

Gilts and Government Bond fund mangers are technically lending your money to governments.  Governments need to borrow money, and this is usually from big banks and large pension and investment funds.

There are basically two types of gilt or government bond:

• Fixed rate bonds are where for a fixed rate of interest (coupon) say for 10 or 20 years is paid with the original capital repaid at the maturity date.
• Index linked bonds are where a government borrows money for 10 or 20 years with the original capital plus inflation is paid back at maturity date.

What Happens When Interest Rates Change?

Interest Rates Increase:

The capital value of the gilt/bond will fall because investors will want a bigger ‘coupon’ return to offset the increase in interest rates.  This is achieved by gilts/bonds that have already been issued being ‘downvalued’.  In short, the interest rate ‘coupon’ stays the same but as the market value of the gilt/bond has fallen, the yield return increases to offset the increase in interest rates.

Interest Rates Reduce:

The capital value of the gilt/bond will rise because investors now only need a smaller ‘coupon’ return to offset the reduction in interest rates.  This is achieved by gilts/bonds that have already been issued being ‘upvalued’.  In short, the interest rate ‘coupon’ stays the same but as the market value of the gilt/bond rises, the yield return reduces to offset the reduction in interest rates.

Remember:

• Investing in funds is for the medium and longer term.  You should not think short term.
• Index linked funds offer medium- and longer-term inflation protection.  Remember current high inflation of CPI at 9% pa and RPI at 11% pa is built into the index linked gilt/bond.
• You may not have benefitted from that return yet, but it is locked into the gilt/bond, and it will be paid out by the government.
• Eventually, interest rates will start to fall or level off.  At this point, maybe in a year or two the index linked gilts inside the fund are one, two, three or 5 years closer to their maturity date when all that lovely inflation growth is paid out.
• Demand for those same index linked gilts/bonds inside your fund will increase even more driving up the value of your fund.

Switch out or Hold?

With further interest rate increases, the value of your index linked fund may fall but never forget the high inflation figures of today are now built into the gilts that your fund owns.

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