Eight-month lag

Index-linked gilts are linked to the Retail Prices Index (All Items), or RPI, with an eight-month lag. The inflation rate calculated from this index is often described as headline inflation, as a short-form name distinguishing it from the so-called underlying measure RPIX, which excludes mortgage interest payments and is the index subject to the Monetary Policy Committee s inflation target. 

For example, the eight month lag means that the principal value of the 2% IL 2006, issued in July 1981 and redeeming in July 2006, will actually be uplifted by the percentage increase in the RPI between November 1980 and November 2005. Investors should note that the RPI was rebased in January 1987 from 394.5 to 100. 

Here, and in the complexity of the real yield calculation, the United Kingdom suffers perhaps for being the prototype linker market. An eight-month lag is needed in order to always know with certainty the future money, or cash, value of the next coupon, so that the money value of that coupon can be accrued. The major innovation of the Canadian model is the use of a formula that accrues coupons on a real basis, removing the need to know precisely what will be paid in cash terms on the next coupon day. 

With an eight-month lag, we will know the next coupon cash flow and possibly the subsequent one, but no others. The formula takes the latest known RPI value and from that month projects all future monthly RPI values using an inflation assumption (currently 3%), which is a market convention. So an unknown RPI in month t is given by... 

This is essentially, but not precisely, the same as saying that the inflation increase in principal is not taxable. There are two reasons why it is not the same. Firstly, if an investor tax year end is, say, December, the relief will be based on the RPI change from December to December, without a lag, whereas indexation occurs with an eight month lag. Secondly, the starting value at the beginning of any tax year is unlikely to be exactly indexed par. 

Index-linked gilts, like all other linkers covered in this chapter, are known as capital indexed bonds, where the income and principal are adjusted for changes in a consumer price index, subject to a lag. In the United Kingdom, the index is the RPI and the lag is eight months. The market trades on a clean price basis, with the quoted price a cash price (not a real price), including inflation accretion. 

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