Heads you win… tails you win?

Can you have your cake and eat it with index-linked bonds?
The Green Line
Steve_Russell
Steve Russell
Investment Director

We live in extraordinary times, and looking at recent political developments, both here and abroad, there is a risk that they could soon become even stranger.

Back in 2007 who would have thought that interest rates would not only be cut to almost zero, but then stay more or less on the floor for the next ten years.

Of course financial assets of all types have flourished in an environment where money (debt) is almost free. Investors in search of some income from their hard earned savings have pushed equity and bond prices up to all time record levels, including UK government index-linked bonds. These are government bonds where the interest rate paid to investors (and the capital returned at the end) is linked to the rate of inflation. This has seen the price of the longest dated such bonds almost triple since the financial crisis in 2008.

Index-linked bond prices are driven by two factors: expectations of future interest rates and future inflation. If interest rates fall or inflation rises, the price goes up. Hence, immediately after the Brexit vote, as sterling weakness pushed up inflation and UK interest rates were cut, the price of these bonds rose rapidly from £200 to £270.

So owners of these index-linked bonds win if interest rates fall, as has been the case for the last decade. But, importantly, they also win if inflation rises, as we fear may be the case in the coming decade as increasingly populist governments threaten to let loose their fiscal bazookas.

What price sterling and UK inflation if Jeremy Corbyn comes to power? Even if that does not come to pass, we believe the rising risk of fiscal (rather than monetary) stimulus poses significant upside risks for inflation.

Of course there is no such thing as an asset with no downside. You may be a winner on either heads (inflation) or tails (low interest rates) with index-linked bonds, but the coin could land on its side.

This would be the equivalent of growth and interest rates returning to pre-crisis levels – unlikely in our view given the excessive debt levels, but not impossible. In such a case these index-linked bonds would fall very significantly.

The political winds seem to be shifting towards a more inflationary outcome, but index-linked bonds – especially the long duration bonds shown here – can also be volatile. So, reflecting this, at Ruffer we ensure that our portfolios have about 15% invested in long-dated index-linked bonds, alongside more conventional assets such as equities and gold.

So can you have your cake and eat it? Of course not, but for investors’ portfolios UK index-linked bonds may turn out to be the next best thing.

Ruffer linkedin
Share on LinkedIn
Ruffer print
Print to PDF
Infini-QE: helicopter money
April 2019: Central bank policies have favoured the ‘haves’ and the ‘have yachts’. Quantitative easing in the next crisis might look very different
Read
Safe as houses?
March 2019: Over almost 30 years UK house price gains have outperformed the best of British businesses. What next?
Read
TINA turning?
February 2019: Rising returns on cash may cause investors to withdraw from riskier assets such as equities and corporate bonds
Read

Chart source: Ruffer LLP and Bloomberg (UK 2055 index-linked bond)

Past performance is not a guide to future performance, investments can go down as well as up and you may get back less than you originally invested. The information contained in this document does not constitute investment advice or research and should not be used as the basis of any investment decision. References to specific securities are included for the purpose of illustration only, they are not a recommendation to buy or sell.

our thinking
Investment Review
July 2021: We have been talking of inflation for well over a decade – which is not the same thing as calling its timing. An impasse was created by the failure of the economy to grow after the 2008 crisis – all the risks (as we patiently explained) were deflationary, and in vain did the central banks and governments try to force an inflationary impulse into a sluggish world.
Audio icon
Bitcoin – the future arrived early
July 2021: The best investments are often the least comfortable ones. This is certainly the case with our decision to add bitcoin exposure to our portfolios in November last year.
Responsible Investment Report
In our latest quarterly report, Investment Manager Rory Goodman examines the global significance of US President Joe Biden's new emission reduction targets announced at the Earth Day summit, and we share our stewardship and engagement activities during the second quarter of 2021.
Navigating information
It’s easy to be overwhelmed by the volume of information aimed at us. Inundated by a daily torrent of headlines, images, messages and data, we can be left feeling unable to process it to a satisfying degree. For investors, navigating information is central to being effective. Insights from information theory and gauge theory can help.
OUR THINKING – ALL ARTICLES
London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussman
75008 Paris, France
London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussman
75008 Paris, France