UK Conventional vs Index-Linked Gilts

UK investors and global bond allocators face a choice analogous to the US decision between Treasury notes and TIPS: conventional gilts (fixed-coupon) versus index-linked gilts (RPI-adjusted principal and coupon). Conventional gilts offer a fixed nominal return and simplicity; index-linked gilts offer an inflation-adjusted return and protection against price surprises. The choice depends on inflation expectations and whether your liabilities are fixed in nominal or real terms.

Key takeaways

• Conventional gilts pay a fixed coupon and are subject to inflation risk; real returns depend on inflation outcomes
• Index-linked gilts adjust principal and coupons with the Retail Price Index (RPI), locking in a real return
• The breakeven inflation rate (spread between conventional and index-linked yields) indicates fair value for choosing between them
• Pension funds and endowments often allocate heavily to index-linked gilts to match inflation-indexed liabilities
• The RPI index used for index-linked gilts is broader than CPI, typically running 0.5–1.0% higher
• Real yields on index-linked gilts fluctuate based on growth and rate expectations, not inflation

Structure comparison: the mechanics side by side

Conventional gilt example:

• £10,000 purchased at par
• 4.0% fixed coupon
• Semi-annual coupon of £200
• At maturity in 10 years, receive £200 semi-annually plus £10,000 principal

Your total nominal return is the coupon plus principal. Your real return depends on inflation during the holding period.

Index-linked gilt example:

• £10,000 purchased at par
• 1.5% real coupon
• Principal adjusts monthly by RPI
• Coupons are 1.5% of the adjusted principal
• At maturity, receive adjusted principal plus final coupon

If RPI inflation is 2.0% per year, after one year your principal is £10,200 and your annual coupon is £153 (1.5% of £10,200), not £150. Your total return is still 1.5% real.

Breakeven inflation rate and decision rules

The breakeven inflation rate (also called the "inflation break-even" or "linker spread") is the difference between the conventional gilt yield and the index-linked gilt real yield. As of 2024:

• 10-year conventional gilt yield: 4.2%
• 10-year index-linked gilt yield (real): 1.8%
• Breakeven inflation rate: 2.4%

This means the market expects RPI inflation to average 2.4% per year over the next 10 years. If you believe inflation will exceed 2.4%, index-linked gilts offer better value. If you believe inflation will fall below 2.4%, conventional gilts offer better value.

Decision framework:

• Inflation expectations above breakeven → Buy index-linked gilts
• Inflation expectations below breakeven → Buy conventional gilts
• Uncertain about inflation → Hold both in a 50-50 split

The RPI distinction and linker specifics

A critical nuance: UK index-linked gilts use the Retail Price Index (RPI), which includes housing costs and is calculated differently than the Consumer Price Index (CPI). As of 2024, RPI inflation is typically 0.5–1.0% above CPI inflation. This is a feature for linker holders: you get slightly more inflation protection than CPI-based measures would imply.

Additionally, index-linked gilts have a "floor" protection: if cumulative RPI is negative (deflation), the principal cannot fall below par. This asymmetry—full upside in inflation, capped downside in deflation—is priced in through lower real yields on index-linked gilts.

Real yield sensitivity and interest-rate risk

Index-linked gilts are still subject to interest-rate risk, but it manifests as changes in real yields, not inflation-adjusted nominal yields. If real yields rise (perhaps because growth expectations fall and the BOE signals future rate cuts), index-linked gilt prices fall. If real yields fall, prices rise.

Example: In 2022, as the BOE began raising rates sharply, real yields on index-linked gilts rose from near zero to 1.8–2.0%. Investors who held index-linked gilts saw their market values decline, even though inflation remained elevated. The decline reflected expectations for lower future real interest rates, not inflation surprise.

This real-yield sensitivity is often overlooked by retail investors, who view linkers as "inflation-proof." They are inflation-proof only if you hold to maturity. In the short run, linker prices can fall sharply if real yields spike.

Pension fund and endowment allocation

UK pension funds and endowments hold high percentages of index-linked gilts because their liabilities are often inflation-indexed. A pension plan paying a 3% annual increase in benefits has an inflation-linked liability. By holding index-linked gilts yielding, say, 1.8% in real terms, the pension fund can nearly match the real value of its future payment obligations (assuming 3% annual benefit increases and 1.8% real yield, the funding ratio slowly declines, but the approach ensures that nominal funding grows with inflation).

For endowments with spending targets pegged to inflation (e.g., "spend 5% of assets annually, adjusted for inflation"), index-linked gilts are a natural anchor. They ensure that as inflation rises, the endowment's asset value and spending rise in tandem.

Nominal vs. real: which matters for you?

The choice between conventional and index-linked gilts depends on whether your future liabilities are fixed in nominal or real (inflation-adjusted) terms.

Your liabilities are fixed in nominal terms if:

• You need a specific pound amount in the future (e.g., £100,000 for a child's wedding in 15 years)
• You're saving for a specific purchase (e.g., a down payment on a house at a target price)
• You want a fixed income stream in nominal pounds

In these cases, conventional gilts are appropriate. You lock in a fixed nominal payment.

Your liabilities are fixed in real terms if:

• You need a retirement income that maintains purchasing power (e.g., £50,000 per year, adjusted annually for inflation)
• You're saving for education costs that inflate over time
• You want certainty about real (inflation-adjusted) returns

In these cases, index-linked gilts are appropriate. You lock in a fixed real payment.

Comparing yields and expectations: a practical example

Suppose you're a UK pension fund deciding whether to hold conventional or index-linked gilts. On January 1, 2024:

• 10-year conventional gilt: 4.2% yield
• 10-year index-linked gilt: 1.8% real yield
• Breakeven inflation: 2.4%

The pension fund's benefit increase is 3% per year. If inflation averages 3%, the fund would be better off with index-linked gilts (earning 1.8% real, which matches the 3% nominal increase when inflation is 3%). If inflation averages 2.0%, the fund would be better off with conventional gilts (earning 4.2% nominal, which is 2.2% real if inflation is 2.0%, beats the 1.8% real from linkers).

In this scenario, the pension fund's view on inflation should drive the decision. If it expects inflation to exceed 2.4% in the medium term, linkers are cheaper. If it expects inflation below 2.4%, conventional gilts are cheaper.

Duration and price volatility comparison

Both conventional and index-linked gilts have significant interest-rate (or real-yield) sensitivity. A 10-year conventional gilt has a duration of roughly 8.5 years. A 10-year index-linked gilt has a duration of roughly 8.5 years (in real terms). Both experience similar price swings in response to yield changes.

However, the source of volatility is different:

• Conventional gilts: prices fall if nominal yields rise (due to growth, inflation, or policy expectations)
• Index-linked gilts: prices fall if real yields rise (due to growth or policy expectations)

In inflationary periods, conventional gilt prices and real yields often move together (nominal yields rise), while index-linked gilt real yields might be stable or falling (as inflation hedges become more valuable). This dynamic can create periods where the two move in opposite directions, providing diversification.

Tax implications for UK residents

For UK residents, both conventional and index-linked gilts enjoy tax exemption on interest. However, the phantom income from index-linked gilts (the annual RPI adjustment) is technically subject to income tax, though in practice this is rarely enforced by HMRC for personal holders. For pension funds and institutional holders, the treatment is clearer: phantom income is taxable in the tax year it accrues.

For US residents or global investors holding UK gilts, the tax treatment is more straightforward: interest and gains are taxable as ordinary income and capital gains, respectively, with no special treatment for inflation adjustments.

Building a gilt allocation: the blend approach

A diversified gilt allocation might split between conventional and index-linked gilts based on inflation view and liability structure:

• Conservative approach: 70% conventional, 30% index-linked. This maintains exposure to nominal returns while hedging inflation risk.
• Inflation-conscious approach: 50% conventional, 50% index-linked. This is neutral on inflation; you're equally positioned for inflation surprise in either direction.
• Inflation-protected approach: 30% conventional, 70% index-linked. This assumes inflation will run higher than the breakeven rate.

An alternative is a dynamic approach: rebalance between conventional and index-linked gilts as your inflation view changes. If the breakeven rate is 2.0% and you believe inflation will be 3%, you shift toward index-linked. If the breakeven rises to 3.5% and you believe inflation will be 2.5%, you shift toward conventional.

The term premium and long gilts

Longer-dated index-linked gilts offer higher real yields (the term premium) but with more real-yield risk (duration). A 10-year index-linked gilt might yield 1.8%, while a 30-year linker yields 2.2%. The extra 0.4% reflects compensation for duration and inflation-term risk (the risk that inflation volatility increases over 30 years).

For investors with long-dated liabilities (pension funds, endowments), this term premium is often worth accepting. For shorter-term savers, the extra real yield may not justify the extra volatility.

Market liquidity and trading

Conventional gilts are more liquid than index-linked gilts. The most traded conventional benchmark gilts (2-, 5-, 10-, 20-year) have tight bid-ask spreads (1–2 basis points). Index-linked gilts are less actively traded, with spreads of 3–5 basis points or slightly more. For buy-and-hold investors, this matters little; for frequent traders, the tighter spreads on conventional gilts are preferable.

Historical performance and lessons

From 1997 (inception of linkers) through 2024, UK index-linked gilts have delivered returns equal to their real yields plus inflation—as theory predicts. Conventional gilts have delivered variable returns based on inflation surprise and nominal yield changes. Periods of high inflation (2008, 2022–2023) have favored index-linked gilts; periods of low inflation (2010–2021) favored conventional gilts.

This history illustrates that no single instrument is always superior. The choice between conventional and index-linked gilts depends on your inflation forecast, liability structure, and time horizon.

Conclusion: match instruments to liabilities and expectations

Choose conventional gilts for simplicity, when inflation expectations are below the breakeven rate, or when your liabilities are fixed in nominal terms. Choose index-linked gilts for inflation protection, when inflation expectations are above the breakeven rate, or when your liabilities grow with inflation. When uncertain, hold both and rebalance as your views and circumstances change.

Conventional vs. index-linked decision flowchart

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