Index-Linked Gilts Explained — How UK Inflation-Protected Government Bonds Work
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Key Takeaways
Index-linked gilts adjust both coupon and principal in line with UK RPI, guaranteeing a real return above inflation.
UK long-term gilt yields stand at 4.45% while index-linked real yields are approximately 0.8-1.2%, implying breakeven inflation of 3.2-3.7%.
Index-linked gilts outperform conventional gilts when actual inflation exceeds the breakeven rate, and underperform when inflation is lower.
Investors can access index-linked gilts through brokers, ETFs like iShares INXG, or pension scheme bond funds.
Long durations (15-30+ years) make index-linked gilts sensitive to real yield changes — consider short-dated options to reduce interest rate risk.
With UK long-term gilt yields at 4.45% and inflation remaining a persistent concern for British investors, index-linked gilts offer something conventional bonds cannot: a government-backed guarantee that your returns will keep pace with rising prices. These inflation-protected securities adjust both their principal and interest payments in line with the Retail Prices Index (RPI), providing a real return regardless of what happens to the cost of living.
Index-linked gilts make up roughly a quarter of the UK government's outstanding debt, yet many investors — particularly those more familiar with US Treasury Inflation-Protected Securities (TIPS) — find their mechanics confusing. Understanding how they work, what they actually pay, and when they make sense in a portfolio is essential for any fixed-income investor navigating the current rate environment.
How Index-Linked Gilts Work
Real Yields and What They Tell You
UK Long-Term Gilt Yields (Monthly)
Index-Linked Gilts vs Conventional Gilts
How to Buy Index-Linked Gilts
Role in a Portfolio
Breakeven Inflation Implied by Gilts
Conclusion
Index-linked gilts provide UK investors with a government-backed guarantee of real returns — something conventional bonds cannot offer. With long-term gilt yields at 4.45% and index-linked real yields around 0.8-1.2%, the market implies breakeven inflation of roughly 3.2-3.7%. If you believe UK inflation will exceed this range over your investment horizon, index-linked gilts offer better value than conventional alternatives.
For most investors, the practical approach is a blend: conventional gilts or gilt funds for predictable nominal income, supplemented by an index-linked gilt allocation for inflation protection. The exact split depends on your inflation expectations, investment horizon, and whether you're building income for retirement or simply diversifying a broader portfolio.
Disclaimer: This content is AI-generated for informational purposes only and does not constitute financial advice. Consult qualified professionals before making investment decisions.
Index-linked gilts are bonds issued by the UK government (HM Treasury via the Debt Management Office) whose payments are tied to the UK Retail Prices Index. Unlike conventional gilts that pay a fixed coupon, index-linked gilts adjust both the coupon and the principal in line with inflation.
The mechanics work as follows: when the bond is issued, it has a stated real coupon — typically quite low, often between 0.125% and 2%. This coupon is paid on an inflation-adjusted principal. As RPI rises, the principal increases, and the coupon payment (calculated on the higher principal) rises with it. At maturity, you receive the inflation-adjusted principal rather than the original face value.
Example: A £1,000 index-linked gilt with a 0.5% real coupon and 3% annual inflation would pay approximately £5.15 in year one (0.5% × £1,030), £5.30 in year two (0.5% × £1,060.90), and so on. At maturity, you'd receive the fully inflation-adjusted principal.
There's an important technical detail: the inflation adjustment uses an eight-month lag. January's coupon payment, for instance, is based on the RPI reading from the previous May. This lag means index-linked gilts don't provide perfect real-time inflation protection, but over the life of the bond, the cumulative adjustment closely tracks actual inflation.
New-style vs old-style: Gilts issued after 2005 use a three-month indexation lag (aligned with international practice), while older issues use the eight-month lag. Both achieve the same purpose — the difference is technical rather than economic.
The real yield on an index-linked gilt is the return you earn above inflation. When you see an index-linked gilt quoted at a yield of 0.8%, that means you'll earn 0.8% per year on top of whatever RPI does over the bond's life.
Real yields have been on a journey. During the post-pandemic period, they were deeply negative — investors were effectively paying the government to protect them from inflation. As central banks raised rates aggressively through 2023-2024, real yields turned positive and have remained there.
The relationship between real yields and nominal yields follows a simple identity: Nominal yield = Real yield + Breakeven inflation. With conventional long-term gilts yielding approximately 4.45% and index-linked gilts of similar maturity offering real yields around 0.8-1.2%, the implied breakeven inflation rate is roughly 3.2-3.7%. This means the market expects UK inflation to average around 3.2-3.7% annually over the long term.
If actual inflation exceeds this breakeven rate, index-linked gilts will outperform conventional gilts. If inflation falls below it, conventional gilts win. The breakeven rate is your decision threshold.
For comparison, US TIPS currently carry an average real yield of 0.983%, placing UK and US inflation-protected government bonds in a similar yield range. The 10-year US Treasury nominal yield at 4.02% and UK long gilts at 4.45% reflect both the real yield differential and differing inflation expectations between the two countries.
The choice between index-linked and conventional gilts depends primarily on your inflation expectations and investment goals.
Conventional gilts pay a fixed coupon on a fixed principal. You know exactly what you'll receive in nominal terms. If you buy a conventional gilt yielding 4.45%, you'll get 4.45% per year regardless of inflation. The risk is that inflation erodes your purchasing power — a 4.45% return with 3% inflation delivers only about 1.45% in real terms.
Index-linked gilts guarantee a real return. If you buy at a 1% real yield, you'll earn 1% above inflation every year. The trade-off is a lower nominal yield in most scenarios — you only come out ahead if actual inflation exceeds the breakeven rate.
When index-linked wins: Periods of unexpectedly high inflation. The UK's experience in 2022-2023, when CPI spiked above 10%, illustrated this dramatically. Conventional gilt holders saw their real returns turn deeply negative, while index-linked gilt holders received upward-adjusted payments.
When conventional wins: Periods of falling or stable low inflation. If UK inflation settles at 2% (the Bank of England's target), a conventional gilt yielding 4.45% delivers 2.45% real — well above the ~1% real yield on index-linked gilts.
Duration risk: Index-linked gilts tend to have very long durations (often 15-30+ years), making them more sensitive to changes in real interest rates. A portfolio of short-dated conventional gilts may actually provide better capital preservation than long-dated index-linked gilts in a rising rate environment.
UK investors have several routes to index-linked gilt exposure.
Direct purchase through a broker: UK stockbrokers and investment platforms (Hargreaves Lansdown, AJ Bell, Interactive Investor) allow you to buy individual index-linked gilts on the London Stock Exchange. The minimum purchase is typically one gilt (£100 nominal), though transaction costs make larger purchases more economical. This approach lets you choose specific maturities and real yield levels.
Index-linked gilt funds: The iShares UK Index-Linked Gilts ETF (INXG) tracks the Bloomberg UK Government Inflation-Linked Bond Index, providing broad exposure across maturities. Vanguard UK Inflation-Linked Gilt Index Fund offers a similar product in fund format. Expense ratios are typically 0.10-0.25%.
Short-dated options: For investors concerned about duration risk, the Lyxor Core UK Government Inflation-Linked Bond ETF focuses on shorter-dated index-linked gilts, reducing interest rate sensitivity while maintaining inflation protection.
Pension schemes: Many UK defined contribution pension schemes include index-linked gilt funds as a default or optional allocation, particularly in lifestyle strategies that shift towards bonds as members approach retirement.
Note that index-linked gilts are not available through National Savings & Investments (NS&I), which offers its own inflation-linked product (Index-Linked Savings Certificates) on a different basis — see our separate comparison of NS&I vs gilts for details.
Index-linked gilts serve a specific function: protecting the real value of wealth against unexpected inflation. They are not a substitute for conventional bonds in all scenarios, nor are they appropriate as a portfolio's entire fixed-income allocation.
Retirement planning: Index-linked gilts are particularly valuable for pre-retirees and retirees whose spending is directly tied to inflation. A ladder of index-linked gilts maturing to match expected spending needs can create inflation-proof income streams — something no conventional bond portfolio can guarantee.
Inflation hedging: Within a broader portfolio, a 10-20% allocation to index-linked gilts provides insurance against inflation surprises. The current breakeven inflation rate of ~3.5% means you're paying a moderate premium for this insurance — but the peace of mind may be worth it given the UK's recent inflation volatility.
Diversification: Index-linked gilts have low correlation with equities and even with conventional gilts in inflationary periods. This makes them genuinely diversifying in a way that other bonds may not be.
With the Bank of England navigating between persistent services inflation and slowing economic growth, and the Fed funds rate at 3.64% on a declining trajectory, the global rate environment is shifting. For UK investors, index-linked gilts offer a way to participate in the government bond market without taking a directional bet on where inflation settles.