How inflation-linked gilts work

The UK government issues two types of gilts: conventional and index linked. Most gilts (around 75%) are conventional, meaning that the coupon remains fixed for the duration of the bond, as well as the principal value that is returned when the gilt matures.

For the other 25% of gilts in issue, two semi-annual coupons and the final principal on maturity are adjusted depending on the level of Retail Price Index (RPI) inflation over the gilt’s life.

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RPI includes mortgage interest payments which are heavily impacted by interest rates, while CPI takes no account of housing costs. As a result, RPI typically comes in higher than CPI.

Investors can therefore use inflation-linked gilts to secure income protection with the inflation rate as the coupon and principal will maintain their purchasing power over the life of the bond.

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The “real yield” (inflation adjusted) is what investors receive when they buy the gilt, either at issue or in secondary markets.

Index-linked gilts are traded and issued in the same way as regular gilts, so can be bought on the secondary market on our platform, or via auctions held by the Debt Management Office that we offer access to. Index-linked gilts must be dealt over the phone at interactive investor, but regular online dealing costs apply. 

The first index-linked bond (or gilt) was issued in 1981 for large institutional investors such as pension funds. This means that index-linked gilts tend to have longer maturity dates to allow large investors to match their liabilities with their assets over long periods without having to worry about inflation.

The UK has the highest proportion of index-linked debt in the world, according to CG Asset Management, with 33 gilts in issue worth £620 billion.

How are inflation adjustments calculated?

A UK Inflation-Linked Gilt (ILG) adjusts both the principal and interest payments for inflation. 

Michael Smith, of stockbroker Winterflood, which deals gilts, explains: “Let’s assume a £100 face value inflation-linked gilt (ILG) is issued in January 2020 with a 1.5% interest rate (paid semi-annually, 0.75% each period). 

“On the first coupon payment date in June 2020, the £100 face value is adjusted for the change in inflation since issue. The change in inflation is calculated as the percentage change RPI since issue. If the RPI is 290 at issue (in January 2020) and if the RPI used for the first coupon payment date in June 2020 is 304.5, then the change is 5%.”

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One thing to note with respect to UK ILGs is that the RPI index level used on a coupon payment date is the level three months prior. Therefore, in this example, since the coupon payment is in June, March’s RPI level would be used.

In Winterflood’s worked example, March’s RPI level is assumed to be 304.5. To calculate the new value of the index-linked gilt and the interest payable:

• The change in inflation is 5% (304.5/290 = 1.05)
• The £100 investment will have grown to £105 (£100 x 1.05 = £105) on the first coupon payment date. £105 is the new nominal value 
• The semi-annual interest payment of 0.75% (half of 1.5%) is applied to the new nominal value of £105 and so the interest payment would be approximately £105 x 0.75% = £0.78
• The inflation adjustment means that investors will receive an adjusted amount of principal at maturity, not just the original face value of £100 (as would be the case with a regular gilt). As the inflation-adjusted principal increases, so too does the interest payable. Hence, the final redemption amount and the cash interest payments are inflation-linked.

When investors buy an inflation-linked gilt on the secondary market, they pay the “dirty” price, which compensates the seller for any accrued interest they have built up before a coupon is paid.

The “dirty” price can differ greatly from the “clean” price due to the growth of the coupons and principal value due to inflation.

What are the biggest risks with inflation-linked gilts?

While index-linked bonds give investors income protection with the inflation rate, providing a stable and predictable return, the price of the bonds can swing dramatically before they mature.

Index-linked bonds are actively traded on secondary markets, meaning that investors can choose to pay more for a bond than its issue price or less, depending on market conditions. Interest rates are the most important factor when pricing bonds. 

When inflation begins to increase, central banks tend to raise interest rates to try and cool inflation. This is what happened in 2022. 

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

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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. 

This can lead to bigger price drops when interest rates rise, but also big jumps in value when they fall.

The result is that index-linked gilts do not necessarily offer protection against inflation over shorter periods as the prices of the bonds could fall dramatically.

However, investors who buy index-linked bonds and hold them to maturity do not have to worry about rising and falling bond prices and can simply enjoy inflation-adjusted returns.

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How are index-linked gilts taxed?

Index-linked gilts are exempt from capital gains tax if an investor buys and sells a gilt and makes a profit. However, income from index-linked gilts via coupons forms part of someone’s income and are taxed at income tax rates.

When held inside an ISA, there is no capital gains or income tax to pay on index-linked bonds. Self-invested personal pension (SIPP) tax rules, such as income tax or the 25% tax free-lump sum, apply to index-linked bonds as they do to other investments. 

How are index-linked gilts priced?

When investors look to buy index-linked bonds, they often make an assessment of what inflation could be in the future.

The yield of an index-linked gilt and a regular gilt maturing at a similar time will therefore actually give a clue about what investors think inflation will be in the future.

The expected inflation rate is called the “break-even” rate of inflation and is calculated by subtracting the yield on an index-linked gilt from the yield on a conventional gilt.

So, if a regular gilt yields 4%, and an index-linked gilt yields 2% (which is then adjusted for inflation), then investors are suggesting that inflation will be 2% until the gilts mature.

If you think inflation will be higher, then you may be better off with an index-linked gilt. If you think it will be lower, then a conventional gilt could offer a better relative return.

CG Asset Management, which runs the Capital Gearing Ord (LSE:CGT) Investment Trust, is a big buyer of index-linked gilts as it thinks that inflation will be higher for longer in the UK.

It argues that globalisation is unwinding which will bring up manufacturing costs, the energy transition will require lots of capital investment which will drive up resource costs, and unionisation in labour markets will drive up wage costs.

Index-linked gilts in issue: March 2025

Source: Tradeweb, 5 March 2025. Note: “Clean Price” does not include any accrued interest. “Dirty Price” is including accrued interest.