What is Index-Linked Gilt?

Full Definition

An index-linked gilt is a type of UK government bond, issued by HM Treasury via the Debt Management Office, whose coupon (interest) payments and final redemption (principal repayment) value both rise in line with a measure of inflation -- specifically the Retail Prices Index (RPI) for UK index-linked gilts -- rather than being fixed in cash terms as with a conventional gilt. Because both the periodic interest payments and the lump sum returned at maturity are uplifted for inflation, an index-linked gilt is designed to preserve the real (inflation-adjusted) purchasing power of an investor's capital and income, which distinguishes it sharply from a conventional fixed-rate gilt, whose fixed cash coupon and redemption value are gradually eroded in real terms by inflation over the life of the bond. Index-linked gilts are particularly attractive to investors and institutions with liabilities that themselves rise with inflation, most notably defined benefit pension schemes, many of which must pay inflation-linked pensions to members and therefore hold index-linked gilts specifically to match (or "hedge") that liability, reducing the risk that unexpectedly high inflation erodes the scheme's ability to meet its pension promises. Individual investors can also hold index-linked gilts directly (bought and sold on the secondary market, or at issue via the Debt Management Office's auction process, though direct participation is more commonly institutional) or indirectly through gilt funds and exchange-traded funds that hold a basket of index-linked gilts, giving retail investors exposure to inflation-protected government debt without buying individual bonds. For UK tax purposes, gilts (including index-linked gilts) are generally exempt from Capital Gains Tax on disposal, meaning any gain arising from movements in the gilt's market price, including gains driven by the inflation uplift itself, is not subject to CGT, which is one of the specific attractions of gilts (alongside their perceived security as government-backed debt) compared with most other investments; interest income received from a gilt, by contrast, including the inflation-linked coupon payments from an index-linked gilt, is generally taxable as savings income under Income Tax, sheltered where applicable by the Personal Savings Allowance and the starting rate for savings, unless the gilt is held within an ISA or pension wrapper, in which case both the income and any gain are entirely tax-free. Worked example: an investor buys an index-linked gilt with a face value of £1,000; if RPI rises by 4% over a year, both the coupon payment due that year and the gilt's inflation-adjusted principal value rise by approximately that 4%, so the investor's income and eventual redemption proceeds broadly track inflation, protecting real purchasing power in a way a conventional fixed-coupon gilt of the same original face value would not.

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