- In this article, we explain what inflation-linked gilts are
- We explore the potential benefits and drawbacks
- A brief look at how inflation-linked gilts might relate to you
Inflation is widely underestimated and works as a silent tax, quietly eroding the purchasing power of hard-earned savings and investments. It’s expected that all investors will at least be looking to generate a return above the rate of inflation, subject to portfolio risk appetite and differing financial goals.
Historic returns indicate that equity markets have been the most successful asset class in achieving this, with real assets, such as infrastructure and property, also commonly utilised. An alternative, and perhaps less widely utilised approach to achieve investment returns in-line or ahead of inflation, is through index-linked UK government bonds, also known as gilts.
What are inflation-linked gilts?
Gilts are securities issued by the government through the Debt Management Office (DMO) on behalf of HM Treasury to fund spending requirements. The securities are issued in units of £100 (the principal value) and have fixed rates of interest (coupons) and a range of maturity dates.
Conventional bonds are the most commonly issued gilt. They pay a coupon twice a year and return their principal value to the investor at maturity. The 4% coupon gilt maturity in 2031 is a useful example. The gilt pays a coupon of £2 semi-annually on the principal value of £100, which is returned to the investor on maturity, alongside the final £2 of interest.
Inflation-linked gilts, also known as linkers, on the other hand, incorporate inflation adjustments into their coupon payments and the principal. The principal rises in line with inflation over the life of gilt, and the semi-annual coupon payments are calculated on this inflation-adjusted figure. The methodology used is linked to the Retail Price Index (RPI) and involves a lag of three-months for those bonds issued after 2005. This is due to the delay associated with the Office for National Statistics needing to calculate RPI data and make any adjustments.
Both conventional and index-linked gilts have similar contractual features, such as coupon rates and maturity dates, but inflation-linked gilts differ in yields being quoted in real terms. An inflation-linked gilt showing a positive real yield is expected to produce a rate of return above that of inflation if held to maturity.
What are the benefits and drawbacks?
The ability to receive inflation protection remains a key attraction of the bonds, providing reassurance when it comes to preserving long-term real value of invested assets. In addition, there is also a tax advantage, with capital gains made on principal values being tax free. Coupons, however, are subject to income tax.
One of the main drawbacks is a lack of income. Of the thirty-four bonds currently in issue, only two have a coupon level of 2% or higher, both of which are old style eight-month lag bonds issued prior to 2005. Most three-month linkers provide coupon incomes below the 1% level, making them less attractive for income seeking investors.
From 2030, a change in methodology will be implemented, moving from the RPI index to a variant of the Consumer Price Index, CPIH, which includes owner occupiers’ housing costs. CPIH, has historically measured lower than that of RPI, leading to a reduction in the rate of indexation to which the bonds’ principal values are linked and potentially a lower rate of inflation-linked return.
How have inflation-linked gilts performed recently?
Prior to 2022, investors in an inflation-linked gilts index enjoyed strong returns. In 2022, however, the asset class failed to perform as investors expected in the face of rising rates of inflation, declining by nearly 34% that year. Part of the cause was the level of interest rate sensitivity in the index, which was very high due to the Government’s ongoing issuance of long-dated bonds to match the high levels of demand of pension funds. As long-dated interest rates increased, the price of the bonds declined sharply with a high level of sensitivity to reflect the lower present value of future cashflows, more than offsetting the rate of inflation linkage of said cashflows.
At the time of writing in June 2026, three-year returns for the broad inflation-linked gilt index remain uninspiring with a loss of 1.53%, mostly due to the ongoing high levels of interest rate sensitivity. A shorter dated index of inflation-linked gilts with maturities below five years, on the other hand, has risen 14.22% over the period, indicating the potential difference in outcomes depending on which bond, or basket of bonds has been purchased.
Index-linked gilts vs conventional gilts
The decision whether to hold an index-linked or conventional gilt depends on your forward-looking inflation expectations. If presented with the option of a 10-year conventional gilt with a yield of 5% and a 10-year index-linked gilt with a real yield of 2%, the breakeven inflation rate is 3%; calculated as nominal yield minus real yield. This figure indicates the market’s expectation for inflation over the ten years. If the actual rate of inflation is greater than the breakeven rate, then the inflation-linked gilt will outperform as the real rate of return achieved by the conventional gilt will be below that of the index-linked gilt. The opposite is true should actual inflation be lower than the breakeven rate.
While the example above is clear cut, reality is not so simple. Inflation expectations are consistently changing, impacted by multiple different factors, making determining whether the market has accurately priced inflation expectations a difficult task.
What are the key takeaways?
Inflation-linked gilts are a useful asset class for investors looking to increase the real purchasing power of their invested capital. Their use in portfolios is likely to be dependent on multiple factors, including time horizon and income requirements, but also in the comfort of the underlying investor with how the prices fluctuate in response to changing market expectations.
For more information on index-linked gilts or any of the themes discussed in this article, please contact your usual Redmayne Bentley office or executive, or call
0113 243 6941.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance. The information and views were correct at time of publishing but may have changed at point of reading.