Index-linked gilt ETFs in focus as BoE highlights inflation risk

Feb 3rd, 2017 | By | Category: Fixed Income

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The Bank of England decided to hold the base rate at 0.25% on Thursday and inflation is forecast to reach a peak of 2.6% in mid-2018, rising from 1.6% in December 2016 and exceeding the BoE’s 2% target.

Index-linked gilt ETFs in focus as Bank of England raises inflation risk

The Bank of England raised its 2017 growth forecast for the UK from 1.4% in November to 2% in its latest report.

Interest rates have been at record lows for around seven years, and industry participants have expressed mixed views on whether they will rise in 2017. The latest minutes from the BoE show the monetary committee members are nearing the end of their tolerance to rising inflation however.

Bank of England Governor Mark Carney warned that tolerance for above-target inflation would be “limited”, suggesting the MPC would work quickly to get the rate back down towards 2%.

Yet they are unlikely to raise rates in a scenario where weaker wage growth and higher inflation squeezes household budgets and dampens consumer spending.

“The Bank of England faces a tough job in the coming months as it seeks to balance a surprisingly resilient economy, higher inflation and the difficult-to-quantify risks posed by Brexit,” noted Ben Brettell, Senior Economist at Hargreaves Lansdown.

Inflation-linked gilt exchange-traded funds could be one option for investors to protect themselves against the risk of inflation rising faster than expected.

While nominal bond prices react to expected future inflation and so yields are already high when inflation expectations are high, inflation-linked bonds on the other hand provide protection against unexpected inflation as their coupon and principal value adjust based on changes in the Retail Price Index. The prices of inflation-linked gilts respond to changes in real interest rates, rather than nominal interest rates.

The £961m iShares £ Index-Linked Gilts UCITS ETF (LON: INXG) costs 0.25% and has returned 19.6% in the last 12 months but has fallen slightly at 0.5% year to date. It tracks the Bloomberg Barclays UK Government Inflation-Linked Bond Index, and physically invests in sterling-denominated inflation-linked gilts with at least one year to maturity.

Another option is the Lyxor FTSE Actuaries UK Gilts Inflation-Linked (DR) UCITS ETF (LON: GILI) which costs just 0.07%, but it has much less assets at £23m. It is also physically replicated and holds the most weighting in bonds with three to five years left to maturity. It is up 18.6% in 12 months but has slipped 0.7% year to date.

Investors might wish to consider index-linked gilt ETFs as tactical exposures rather than long term holdings. Morningstar analysts have noted that investing in passive inflation-linked bond funds long-term is “highly questionable”, as demand for these bonds is driven by large institutional investors such as pension funds and insurance companies.

Investors should remember that fixed income securities issued by the government are also susceptible to the political and economic stability of that country.

“The biggest determinants of the UK’s medium-term prosperity will be the country’s new relationship with the EU and the reforms that it catalyses,” said Carney at a press conference this week.

“These processes will also have a significant varying on inflation over the course of the next few years. Market participants’ views regarding the economy’s future growth potential will influence asset prices, particularly the exchange rate.”

The UK is generally regarded as a safe haven for fixed income investing, and a plummeting sterling currency has increased corporate profits, but recent turmoil around Brexit has made investors more wary. A recent Supreme Court decision ruled that Parliament first had to vote before the government could trigger Article 50, signalling the UK’s departure from the European Union. This has added a fresh layer of uncertainty around the process of enacting Brexit.

But there has been a batch of positive data over the last few months in the UK, too. As the economy has remained resilient since the EU referendum in June, the BoE raised its growth forecast for 2017 from 1.4% in November to 2% in its latest report.

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