Breaking even with inflation

You probably sort of know how index linked gilts, or “linkers,” work. The redemption value is linked to the change in the retail price index, or RPI, that takes place over the life of the gilt. 

by John Royden

Head of Research

Understanding Finance

Investing in linkers is not as easy as it sounds. The price of linkers reflects what the market thinks about inflation over the life of the bond. So if the market is expecting to see high inflation then the prices of linkers will reflect this. If you also expect high inflation then don’t rush to buy linkers and expect to make excessive returns. You will have paid a price that has high inflation baked into it. Keeping it simple, you will only make excessive returns over the conventional gilt equivalent return if inflation turns out to be higher than the market was expecting. The rate of inflation that is baked into the prices of linkers is a maths problem for a large spreadsheet if done precisely and is called the breakeven rate.  

If you look at the yield on a ten year conventional gilt, you can work out what rate of inflation you need to get the equivalent ten year index linked gilt to produce the same final gross redemption yield when the bonds mature. It is not quite as easy as it sounds because you have to remember that the semi-annual coupons are index linked.  Added to which, if you have worked out the inflation implied by the 2022 linker then you have to use that inflation as the first two years of inflation when working out the inflation implied by the 2024 linker.  That is our process at JM Finn.

Understanding Finance

Helping clients understand what we do is key to building relationships. To explain some of the industry jargon that creeps into our world, we’ve pulled together a section of our site to help.

Managing your wealth

Managing your wealth

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Autumn Issue Thirty Two