Don’t be shy, ask ii….why is this inflation-linked bond fund losing money?

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Mr Ganatra asks: towards the end of last year, some experts were suggesting that high inflation may be temporary, but I predicated that it was here to stay for some time. I therefore invested in the Vanguard UK Inflation Linked Gilt Index Fund. My fund is currently down by over 17%. Why is this fund performing poorly when it is meant to protect investors against inflation?

Sam Benstead, deputy collectives editor, interactive investor, says: investing is a tricky business: making the right call about the economy, company profits or interest rates is different to picking the right stocks or fund.

As superstar investor Terry Smith often says, even if he knew what was going to happen in the future it would not help him make good investments. Instead, he sticks to companies that have proven they can survive downturns, and also grow consistently.

You correctly predicted persistent inflation, but have unfortunately been caught out by everything else going on in markets. To understand what’s happening, first we need to look at what the Vanguard inflation-linked UK bond fund owns.

It is packed with UK government index-linked bonds (gilts) with different maturity dates and interest rates. These range from 1.25% for bonds maturing in 2055 to just 0.38% for those maturing in 2062.

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Index-linked gilts differ from conventional gilts in that both the semi-annual coupon payments and the principal payment are adjusted in line with movements in RPI, an inflation measure that also includes housing costs alongside a basket of commonly bought goods.

As inflation rises, payments to investors also rise – in theory this is perfect for investors looking for income that can keep up with inflation and looking to avoid the negative real yields from normal bonds.

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However, bond prices are at the whim of markets, which is why you have lost money this year.

When inflation begins to increase, central banks tend to raise interest rates, as they are doing now. This makes it more expensive to borrow money and reduces consumer spending, cooling the economy and bringing inflation back down to a more comfortable level.

This is bad news for the prices of bonds as investors are no longer getting the best rate and inflation erodes the value of returns. They sell bonds, causing prices to fall and yields to rise.

Last year, inflation was picking up but there was little indication that rates would rise as central banks thought inflation would be “transitory”. This made index-linked bonds one of the best types of bonds to hold.

However, now that rates are rising sharply, this is impacting the price of all bonds. However, index-linked ones are hit particularly hard. Because of high demand from big financial institutions, UK inflation-linked bonds typically take a long time to mature, often more than 20 years.

They therefore have high “duration”: the sensitivity of a bond, or bond fund, to any change in interest rates. The higher the duration, the more sensitive the bond is to a movement in rates. On that basis, and assuming all other things remain equal, if bond yields rise by 0.1%, the price of an index-linked tracker will drop by 2% because of that heightened sensitivity to interest rates.

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This means that investors have been dumping inflation-linked gilts, even though inflation is rising. The prospect of rising interest rates has far outweighed the benefits of an inflation-linked income.

BlackRock, the world’s biggest fund manager, points out that as a general rule for every 1% increase or decrease in interest rates, a bond's price will change approximately 1% in the opposite direction for every year of duration. 

In the case of the Vanguard UK Inflation Linked Gilt Index fund, 40.3% is held in bonds with a credit maturity of more than 25 years.