What are government bonds? UK index-linked gilts explained

UK index-linked gilts are a particular type of government bonds whose performance is linked to inflationary changes. Here’s more on how they work, their potential benefits, and how they’re traded.

What are UK index-linked gilts?

UK index-linked gilts are UK-issued government bonds linked to changes in an inflation index. The principal value of the bond tends to increase with expectations of rising inflation. This means that UK index-linked gilts are often seen as a hedge against inflation, although it doesn’t mean they’re guaranteed to rise in inflationary periods.

Backed by the UK government, these gilts have fixed maturity rates ranging from several years to decades in the future, when bondholders are paid back in full. In general, gilts are seen as one of the safer financial instruments, although past results are no guarantee of future performance.

How do UK index linked gilts work?

UK index-linked gilts, issued by the UK's Debt Management Office, are intended to safeguard investors against inflation by aligning their value with changes in the consumer price index or retail price index. As inflation increases, the bond's principal and coupon payments increase, ensuring a real rate of return.

Since they are backed by the UK government, these gilts offer virtually no default risk and provide liquidity through active trading on platforms like the London Stock Exchange. Investors receive adjusted principal values upon maturity, reflecting inflation changes over the bond's term.

The status of this asset class as being a hedge against inflationary pressures makes it a sought-after option for preserving capital and securing reliable income streams in inflationary environments.

In 2021, expectations of higher inflation caused a rise in the index-linked gilt and a fall in the standard gilt. While the index-linked gilt is designed to protect against inflation and therefore becomes more appealing to buy in the above example, the standard, non-index-linked gilt may see more selling pressure as market participants see the future purchasing power of the gilt’s fixed interest payments to be diminished.

Why are uk index linked gilts important?

UK index-linked gilts are important due to various reasons, from inflation protection to risk management and beyond. Here are some of the key factors.

Inflation protection: as mentioned, UK index-linked gilts provide protection against inflation due to their price movement in line with inflation indices, helping investors preserve their purchasing power in inflationary times.
Risk management and diversification: Due to being an inflationary hedge, index-linked gilts can be a risk management and diversification play in a balanced portfolio, where the prices of other assets you hold may react unfavourably to inflationary pressures.
Stability: Due to their nature of being backed by the UK government, these are considered safe investments with no default risk, with an assured and reliable income stream.
Liquidity: UK index-linked gilts are actively traded in financial markets, meaning they’re easy to buy or sell in a highly-liquid environment.

What impact might inflation have on UK index-linked gilts?

The impact of inflation expectations on UK index-linked gilts is significant but not guaranteed. When the market anticipates higher inflation, the theoretical adjustment suggests that the future interest payments and principal repayment amounts of these gilts should increase because they are indexed to the retail prices index.

This expectation makes index-linked gilts more attractive, driving up their prices and lowering their yields. However, the actual adjustments depend on the realisation of inflation; if actual inflation matches or exceeds expectations, the adjustments will be as anticipated.

Conversely, if actual inflation is lower than expected, the adjustments will be smaller. Thus, while higher inflation expectations typically lead to higher prices and lower yields for index-linked gilts, the exact impact depends on the eventual inflation outcomes and market dynamics.

FAQs

What are gilts?

Gilts are government bonds issued by the UK’s debt management office. When you buy a gilt, you’re effectively lending money to the government in return for regular interest payments, and when the bond matures, you’ll receive back your initial investment. There is usually an inverse correlation between interest rates and gilt prices. Gilts tend to be seen as safe investments due to the government’s ability to guarantee repayment.

What are bonds and gilts?

Bonds are gilts interrelated but have distinct characteristics. While bonds are debt instruments issued by governments to raise capital for public sector spending, gilts are a specific type of bond, generally considered a safer investment compared to other financial instruments. Gilts pay a fixed rate of interest twice a year, with the UK issuing a range of types of gilts, including conventional gilts or fixed-rate bonds, index-linked gilts or inflation-linked bonds, and treasury bills. In summary, all gilts are bonds, but not all bonds are gilts.

How do gilts work?

Gilts work similarly to general bonds but have some key differences. Specifically, it’s the UK government that issues gilts, while other bonds can be issued by various governments. Gilts are also denominated in GBP. The interest payments, or coupon payments, for gilts are typically made on a fixed or twice-yearly basis, while some other bonds have variable or floating interest rates linked to market benchmarks. Gilts also have fixed maturity dates over years or decades, while the terms for other bonds may differ. Also, other bonds may carry more risk depending on the financial health of the issuer.