Most bonds pay a fixed amount of interest and return a fixed sum at the end. Inflation slowly eats away at the value of those payments. Index-linked gilts are the UK government’s answer to that problem: bonds whose payments rise with inflation, so investors are protected against rising prices. They are a large and important part of the UK bond market, and they behave in ways that can surprise beginners.
How they work
An index-linked gilt pays a small coupon, often well under 1%, but both the coupon and the final repayment are adjusted for inflation. Historically the adjustment used the Retail Prices Index, or RPI. From 2030, RPI is due to be aligned with CPIH, a measure that usually runs lower, which affects the value of older bonds.
If inflation rises 5% in a year, the amount the bond pays rises roughly in step. The investor’s return before inflation varies, but the return after inflation, known as the real yield, is fixed at the price they paid.
The UK was one of the first major governments to issue inflation-linked debt, in 1981, and it has one of the largest markets of its kind. Index-linked gilts make up roughly a quarter of the UK government’s debt, a much higher share than in most other countries.
Real yields and breakevens
Because the payments rise with inflation, index-linked gilts are priced in terms of real yield. A real yield of 1% means investors expect to earn 1% a year above inflation if they hold to maturity.
Comparing the yield on a normal gilt with the real yield on an index-linked gilt of similar maturity gives the breakeven inflation rate. If a conventional ten-year gilt yields 4.5% and the index-linked equivalent yields 1%, breakeven inflation is about 3.5%. That is roughly the average inflation rate the market is pricing for the next decade. Traders watch breakevens closely as a market-based read on inflation expectations.
The main buyers
The biggest buyers are UK defined-benefit pension schemes. Their promised pensions often rise with inflation, so inflation-linked bonds are a natural match. That concentrated ownership means demand from pension funds can strongly influence prices, especially at very long maturities.
Why they can be volatile
Inflation protection does not mean price protection. Index-linked gilts are long-dated and pay little income, so their prices are very sensitive to changes in real yields. When real yields jump, prices can fall sharply.
The clearest example came in the autumn of 2022. After the mini-budget, gilt yields surged and pension funds using liability-driven investment strategies were forced to sell assets to meet collateral calls. Some long-dated index-linked gilts lost more than half their value within weeks before the Bank of England stepped in. It was a harsh lesson that inflation protection is not the same as safety.
Why traders watch them
Breakeven inflation feeds into expectations for Bank of England policy. Rising breakevens can signal that markets doubt inflation will return to target, which may push expectations for interest rates higher. Supply also matters: the Debt Management Office’s issuance plans, announced alongside budgets, show how many new index-linked gilts will come to market, and gilt auctions of these bonds are closely watched.
Ways to invest
Investors can buy individual index-linked gilts through many investment platforms or use funds that hold them. Funds can carry their own risks, including high duration, which means larger price swings when yields move.
Our assessment is that index-linked gilts are a valuable tool for protecting against inflation over the long term, but a poor place to hide from short-term volatility, particularly at long maturities. The key watchpoints are breakeven inflation, real yields and the government’s issuance plans. A sustained rise in breakevens alongside falling real yields would point to growing inflation worries. If you want to understand how you approach bond markets and risk, our free trader assessment is a good next step.
