Robin Marshall, M.A., M.Phil,
Paul Amery
key takeaways
- Higher real yields outweighed inflation protection: Inflation-linked coupons and principal increased, but the rise in investors’ required real returns had a much greater effect on bond prices.
- Long duration magnified the losses: UK index-linked gilts have relatively high sensitivity to interest-rate movements, making longer-dated bonds particularly vulnerable as real yields rose.
- The market’s supply-and-demand balance changed: Lower pension fund demand, quantitative tightening, increased government borrowing and stronger global investment needs may all have contributed to higher real yields.
What’s caused UK inflation-linked bonds to perform so poorly in recent years? The answer lies in a change in the required real rate of return investors demand for holding inflation-linked debt. Another contributing factor to the negative performance is the relatively long duration of UK inflation-linked debt during a period of rising yields.
The UK as a case study
UK inflation accelerated in the early 2020s following the government’s emergency monetary response to the coronavirus pandemic. A surge in demand as the economy emerged from lockdown created a demand-pull inflation shock, compounded by the energy supply crisis caused by Russia’s invasion of Ukraine in 2022 (Figure 1).
Yet inflation-linked bonds – the asset class one might (naively) expect to perform best in such circumstances – did not perform well. UK index-linked gilts suffered a major price decline over the period: the FTSE Actuaries UK Index-Linked Gilts Over 15 Years Price Index fell by nearly two-thirds between December 2021 and September 2026 (Figure 2).
Why did this occur? Were the UK’s inflation-linked debt securities not doing their job?
The answer lies in the fact that, since 2020, investors have required higher real rates of return to buy inflation-linked gilts. Although the inflation accruals on these gilts have been higher, they have been swamped by the increase in real yields.
Figure 1: UK Retail Price Index 12-month change (%)
Figure 2: FTSE Actuaries UK Index Linked Gilts Over 15 Years Price Index
The rebound in real yields
An investor in an index-linked gilt receives two forms of returns: the interest coupons and principal repayment on the bond – which are both indexed to inflation. [note1]
If investors hold the bond to maturity, then assuming no default by the issuer, they will receive the inflation-linked coupons and principal.
However, in the interim (i.e., before maturity), inflation-linked bonds’ prices can move substantially. They do so in response to changes in inflation rates and nominal interest rates, which are set by market supply and demand. Remember, unlike a nominal gilt redeeming at 100, there is no unique redemption price for an inflation linked gilt: it will depend on the inflation rate during the bond’s lifetime.
And in the case of over 15-year UK index-linked gilts, real yields have jumped from a low of -2.56% in November 2021 to 2.5% in September 2026 (see Figure 3)—a dramatic increase of over 5% in less than five years.
When combined with the natural interest rate sensitivity (i.e., the higher duration) of longer-dated index-linked bonds, you arrive at the severe price decline shown in Figure 1.
Figure 3: FTSE Actuaries UK Index Linked Gilts Over 15 Years Index real gross redemption yield (%, LHS) at 3% constant inflation
It’s important to add that real yields are not directly observable. They are calculated by assuming an inflation rate during the bond’s lifespan to generate future cash flows and a redemption value for the inflation-linked bond.
Real yields are then backed out by using the Fisher identity (real rate = nominal interest rate – inflation rate). The UK’s Debt Management Office (DMO) has traditionally assumed an annual Retail Prices Index (RPI) increase of 3% to calculate real yields.
Nevertheless, real yields on government-issued inflation-linked debt are helpful in pricing other asset classes, even if they rely on inflation assumptions and are not a perfect guide to investors’ required real rate of return.
They are the closest thing investors have to an indicative inflation-adjusted risk-free interest rate (with no or minimal default risk). So, when real yields alter, they may shift the required rate of return across every other financial instrument, including conventional bonds, equities and real estate.
What’s caused the required real rate of return to jump?
Several factors may be behind the dramatic jump in real yields between 2021 and 2026.
Declining LDI demand
UK defined benefit pension funds seeking to match future inflation-linked pension liabilities were major (and largely price-insensitive) purchasers of UK index-linked bonds in the 2010s, helping push real yields well into negative territory. This demand peaked in 2021-22 and has since reversed slightly (see Figure 4). This net reversal of demand has undoubtedly played a part in boosting index-linked real yields.
Figure 4: Bond split among UK defined benefit pension funds
End of QE and higher government debt issuance
Central banks’ quantitative easing (QE) programmes, introduced in several major economies after the 2008 financial crisis, may have depressed real yields by holding down nominal government bond yields while simultaneously causing longer-term inflation expectations to be higher.
However, since February 2022, this has changed: the Bank of England has been selling the stock of assets it purchased during QE, a process known as 'quantitative tightening' (QT).
QE and QT plans are not set in stone. In a sign it considers the speed of recent bond yield rises to have been excessive, in September 2026 the Bank rewrote its QT plans, saying it would pause all bond sales until April 2027 and stop selling long-dated bonds altogether.
However, it said it would still sell off the remaining £368bn of QE purchases by 2034. In addition, UK fiscal deficits and inflation-linked debt issuance have continued to increase, even if the share of inflation-linked bonds in overall debt issuance has fallen.
A change in Keynes’ investment-saving balance?
Globally, higher real yields may also reflect an adjustment in Keynes’ ex-ante investment-saving balance.
Unlike during the period of weak capital expenditure (capex) and a global savings glut that characterised the era of secular stagnation from 2008 to 2020, there is now a surge in capex linked to artificial intelligence (AI), alongside government infrastructure programmes and the green transition. Put another way, a higher real interest rate helps to encourage the savings required to fund the investment needed to sustain a fast-growing economy.
The recent jump in real yields could therefore partially reflect the extremely high capital expenditure demands coming from the technology sector as a result of the AI boom.
More inflation uncertainty in a new regime?
Recent inflation shocks and higher inflation volatility may also have increased the inflation protection investors require. This includes inflation-linked government bonds, since they are not pure inflation hedges but, like nominal (fixed-rate) bonds, are also subject to interest rate and duration risk. It’s worth noting, too, that UK inflation-linked government bonds have longer average duration than other inflation-linked government bond markets.
UK real yields are below historic highs, but now offer meaningful inflation protection
Finally, it’s worth pointing out that while the recent rise in inflation-linked bonds’ real yields has been dramatic, they are still below historical highs.
UK index-linked gilts, which have the longest and most extensive track record of any inflation-linked government bond market, recorded real yields of more than 4% in the late 1980s and early 1990s. This preceded the multi-decade decline that appears to have ended in 2021, although it should be noted that real yields above 4% occurred under a higher-inflation regime.
Since the 1990s, FTSE Russell has tracked this market’s evolution via our well-known FTSE Actuaries UK Index Linked Gilts indices. It seems reasonable to conclude that the real yields on these indices are a market measure that will remain at the forefront of asset allocators’ minds.
Footnotes
[1] Readers interested in how index-linked gilts’ interest coupons, redemption values, market prices and yields are calculated can refer to the UK Debt Management Office’s website | Back to Note 1
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