Why did index-linked gilts not protect me from inflation?

Q: In 2021 when inflation was high I decided to invest in the Vanguard UK Inflation-Linked Gilt Index Fund. I thought my money and dividends would be protected from inflation. However, the fund has performed poorly and no dividends have been paid out. Why is this?

A: Index-linked gilts – bonds issued by the British Government whose income and capital returns are both tied to inflation – are complex investments and can be very hard to understand. The way they tend to behave when traded on the market adds further complexity. That said, we’ll try to keep things as simple as possible.

The first thing to remember is that these bonds are traded on the open market and hence their price is determined by supply and demand and the motivations of all the investors involved. Any traded asset, even one that on paper sounds as safe as this one, can experience movements in price – in some cases severe ones.

Unfortunately, this is the case with bonds in the period before the return of inflation. Low inflation and low interest rates had caused investors to buy bonds and push their prices to levels that made them vulnerable to any change in those circumstances. Index-linked gilts were caught up in this strong bull run. When inflation returned in late 2021 and the Bank of England started to raise interest rates in response, their prices fell alongside the rest of the bond market.

Inflation and higher interest rates are the very things that make bonds unattractive investments: inflation erodes the value of their future interest payments and eventual maturity value, while higher interest rates make cash a more appealing alternative. You may say that in the case of index-linked gilts (‘linkers’) the first of these two considerations – the effect of inflation – should not apply, but while this is true it was not enough to counteract the bear market conditions that rapidly took hold in the bond market.

Another factor is that the price of gilts in particular had been pushed up by the near-compulsion to own them that applies to investors such as managers of final salary pension funds.

As the graph shows, you were unlucky enough to buy this fund at almost the very peak, just as the return of inflation and higher rates was about to send the bond bull market into reverse.

Important information -investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Eligibility to invest in an ISA and tax treatment depends on personal circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.