A guide to how an index-linked gilt turns a fixed real coupon into cash that moves with the Retail Prices Index, why an eight-month or three-month lag sits between the prices and the payment, and what the gilt does not do.
What an index-linked gilt is
A gilt is a bond issued by the UK government, through HM Treasury, and listed on the London Stock Exchange. A conventional gilt pays a fixed cash coupon twice a year and repays £100 for every £100 of nominal held at maturity. An index-linked gilt is the other kind. It pays a coupon that is fixed as a real rate but adjusted for inflation when it is paid, and it repays a nominal that has been adjusted the same way. The Debt Management Office records the first UK issue in 1981, and describes the UK as one of the earliest developed economies to issue index-linked bonds to institutional investors.
The phrase to hold on to is that the rate is fixed but the cash is not. An index-linked gilt issued with a real coupon of a small fraction of a per cent keeps that fraction for its whole life. What changes is the amount that fraction is applied to, and that amount moves with a published price index.
The real coupon and the index ratio
The index used is the Retail Prices Index, published monthly by the Office for National Statistics. Two values of it matter to a single gilt. The base RPI is the index value at the gilt's first issue, fixed then and never changed afterwards. The reference RPI is the index value the gilt's terms point at for a particular payment. Divide the second by the first and the result is the index ratio.
The ratio starts at 1 on the day of issue and grows, or shrinks, as prices move. Everything the gilt pays is then scaled by it. The cash coupon is the real coupon rate applied to £100 of nominal multiplied by the ratio, and the redemption is £100 multiplied by the same ratio. A reader who wants it in one sentence: the index ratio is the whole mechanism, and everything else in this guide is about where its two inputs come from.
The lag, and why there are two of them
The reference RPI is not the index value for the month a payment falls in. It is the value for an earlier month, and which month is set by the gilt's indexation lag. Two lags are in use on the gilts in issue: eight months and three. Under the eight-month lag the reference value for a payment is the RPI for the month eight months before it; under the three-month lag it is the RPI for the month three months before.
The lag exists because a price index is published after the month it describes. A lag of three months means the governing figure is available roughly two months before the payment; a lag of eight means it is available roughly seven months before. A longer lag therefore makes the cash more predictable and less current: the amount is known further ahead, and it answers to older prices. Both conventions are in issue at the same time, and the Debt Management Office's index-linked data report groups the gilts by which one they carry.
The lag also decides how a gilt is quoted. A three-month-lag gilt is quoted at a real clean price — the price of the gilt with the inflation uplift left out — while an eight-month-lag gilt is quoted at a nominal clean price, with the uplift still in it. On both, the dirty price paid at settlement carries the uplift. It is worth knowing which basis a quote is on before comparing it with anything.
What is fixed and what moves
| What | Fixed or moving | What follows |
| Real coupon rate | Fixed at issue | The rate never changes |
| Nominal per £100 | Moves with the index ratio | Every payment is scaled differently |
| Cash coupon | Moves | Rises with prices, and can fall |
| Redemption | Moves | More or less than £100, depending on the index |
| Payment dates | Fixed, six months apart | Rolled to the next business day if needed |
A worked illustration makes the scaling concrete, and every input here is stated because none of it is a quote from a gilt. Take a real coupon of 0.125 per £100 nominal, an index ratio of 1.35000 and a holding of £10,000 nominal. The cash coupon is £0.125 × 1.35, or £0.16875 per £100, which on £10,000 is £16.875 a year, paid in two instalments. The redemption is £10,000 × 1.35, or £13,500. At a ratio of 1.40000 the same gilt would pay £17.50 a year and repay £14,000.
Reading the yield of an index-linked gilt
Because the cash is indexed, the natural measure of an index-linked gilt's return is a real yield: the return after the inflation the gilt is priced for, rather than the cash return. A real yield is what lets two index-linked gilts be compared with each other, since both are being measured on the same basis and neither is flattered by the inflation already banked in its ratio. A net real yield deducts income tax on the coupons at a stated rate, which is what makes gilts with different real coupons comparable once tax is in the picture.
A real yield on its own does not say what the cash return will be, because that depends on the inflation still to come. To bridge the two, the market's own prices can be read: a nominal gilt and an index-linked gilt of the same maturity are issued by the same borrower, so the gap between a cash yield and a real yield is largely the inflation the market is pricing over that horizon. GiltIQ states that gap as implied RPI, derived from the fitted nominal and real yield curves at each gilt's own term.
Implied RPI is a market price rather than a forecast, and it is not the same number as the ONS's published RPI annual rate, which records the last twelve months. Where a projection needs cash flows beyond the last published index value, the site applies an assumed inflation rate and marks the resulting figure as an estimate.
What an index-linked gilt does not do
It is common to describe these gilts as protecting a holding against inflation. That description is too strong, and the list below sets out the limit of what the mechanism actually delivers.
- It does not fix the cash. The Retail Prices Index can fall as well as rise, and the Debt Management Office says in terms that index-linked cash flows can therefore fall.
- It does not remove the lag. Both conventions carry one, so the cash answers to prices from months earlier rather than to prices now.
- It does not match a household's own costs. The index measures a basket of prices, not one reader's spending.
- It does not stop the price moving before maturity. A holding sold early can return less than it cost, in real terms as well as in cash.
- It does not promise a positive real return. A real yield can be negative, and the real coupon was fixed when the gilt was issued.
Where to look, and what this guide is
The index-linked gilts in issue lists every one of them with its clean price, accrued interest, index ratio at five decimals, dirty price, real yield and net real yield, so the mechanism above can be seen working on real gilts rather than on an illustration. The conventional gilts in issue is its counterpart, and reading the two lists side by side is the quickest way to see what is different about an indexed coupon.
This guide explains how index-linked gilts work; it is general background, not investment, tax or legal advice for any reader's circumstances. The gilt's terms and the indexation lag are described by the Debt Management Office, and the Retail Prices Index is published by the Office for National Statistics, which are the primary sources for each; the illustration above is illustrative and its inputs are stated. Neither kind of gilt is free of risk, and an index-linked gilt's cash can fall.