Why Gilts Should Be On The Menu For LGPS Fund Allocations

Treasury gilt yields have risen to touch 6% at the 20-to-30-year tenor.  That is more than the discount rate for most LGPS funds.  The real yield on index-linked gilts is 2.5%, so investors can lock in that yield while getting complete certainty on future cashflows as well as full mitigation against inflation.  Both those propositions must be attractive to any open Defined Benefits (“DB”) Scheme, whether active or not.  But while some LGPS funds are beginning to raise weightings, most still fight shy.  This article explores some of the reasons behind this.

What has been driving bond yields higher this year?

There are three main explanations being given for the rise in bond yields this year.  The first is that the inflation fundamentals are deteriorating.  For thirty years, the Federal Reserve has used monetary easing as its weapon of choice whenever trouble hit.  While Warsh, the Chair since May 2026, is trying a different approach, he is ultimately constrained by the politics: he must avoid a collapse of the financial system at a time when the U.S. is fighting two wars.  When push comes to shove, he will probably have to revert to some form of quantitative monetary easing.

The outcome of loose monetary policy over so long a period should, other things being equal, be higher inflation.  No surprise then that bond investors today are less willing to pay up for government bonds whose future cash stream is fixed in nominal terms.

The second explanation is the profligacy of governments, and especially the United States.  Here, the primary deficit is of the order of 6% of GDP and the US$40 trillion of debt amounts to more than 120% of GDP.  Some would say that it is already too late to avoid falling down the slippery slope towards the magic money tree.  It would certainly require a dose of austerity similar to Geoffrey Howe (in the U.K.) and Paul Volcker in the late 1970s.  There is no sign whatsoever that politicians are ready to do that.  In the absence of political will the tramp of the bond vigilantes is therefore getting louder.   

The third explanation is competition for capital.  The amount of debt being raised to finance AI is expected to reach into the $US trillions over the next few years, and it must be displacing some government borrowing – hence higher bond yields. 

Personally, I have the most sympathy for the last of these.  If either of the first two were true, I would expect the term premium (i.e., the extra return over the short-term policy rates expected by investors for investing in long duration bonds) to have risen this year.  But, at least in the U.S. it has hardly changed in 2026.  That suggests that worries over inflation or government debt levels are not behind the rises.

Conventional gilts today offer a good match for LGPS liabilities

The question remains why LGPS pension funds are so wary of these attractive yields.  Go back a generation, and an open active Defined Benefit Scheme would have had around 40% in gilts.  The LGPS allocation to all gilts as at March 2025 was below 6% according to the Scheme Advisory Board.  Most of that is to Index-Linked gilts, and not to conventionals.  18 months later that weighting will certainly be higher, but my experience is that there still seems to be substantial resistance to increasing fixed income allocations.

I am not saying that 40% is the right allocation today, as the universe of fixed income assets is far wider – think private credit and corporate bonds.  However, at current yield levels there can be no doubt that gilts constitute a good match for pension fund liabilities.

What about index-linked gilts?

Index-linked gilts additionally provide almost full mitigation against a rise in consumer inflation because both their coupons and capital are fully indexed to CPI.  (Yes, there is a slight wriggle that some short-dated gilts are still indexed to RPI).  That is why they offer lower yields than conventionals at around 2.5% + inflation compared to 5.9% (at the 20-year tenor).

The difference between these numbers is 3.4%, which is the break-even inflation rate.  The maths says that at that inflation rate the level of prices will nearly double over 20 years.  Investors who prefer linkers to conventionals today are betting that inflation will be higher than that.

If we go back in history, it has taken about 30 years for prices to double.  It is definitely not impossible that they will do so again in the next 20 years, but it is undoubtedly a bold statement.  By comparison, most actuaries’ inflation assumptions is around 2.5% for the same period.  At the moment conventional gilts therefore seem to me to offer better value than linkers.

Why aren’t LGPS allocations to gilts much higher?

The question I ask is why LGPS funds are not investing a lot more into gilts generally, and in conventional gilts in particular.  The pools are now responsible for investment and are taking over the advisory function.  But the strategic asset allocation decision still primarily sits with the funds, not the pool, and they are in the process of setting their Strategic Asset Allocation. 

It may be that officers and advisers believe gilt yields still have further to rise for the reasons given above.  That may turn out to be right, but at current levels gilts are attractive to pension funds for the reasons given above.  They may yet become more attractive over the coming months, but equally they may not.

The malign influence of the 2022 gilts crisis

It may be a more psychological reason.  I’ve regularly heard the comment in committee meetings that holding gilts has cost the private sector a lot of money since the 2022 gilts crisis.  They are right – it has, and it has continued to do so.  The second barrel is usually that index-linked gilts failed to provide protection – they went down in value substantially while inflation touched on 10% in 2022.  Again, the data shows they are right here too.  Compared to equities, which have delivered returns year after year, gilts feel risky.

These arguments miss the point.  The cashflow from an index-linked gilt even in 2022 still provided full mitigation against inflation.  But linkers also exhibit long duration:  for example, a 20-year linker today has a modified duration of 19 years, and the longest maturity one in issue 44 years.  A 1% rise in the real yield today would mathematically result in a 19% fall and 44% respectively. 

The private sector DB funds who held them in 2022 had, in some cases, purchased them at negative or very low real yields to mitigate the risk of higher inflation.  But their long duration meant that the capital losses from higher real yields overwhelmed the inflation benefit.  For example, from bottom to top, as real yields moved from an extreme low of -3% in 2020 to +2% in 2026 the capital loss on a 20-year linker was over 60%.  The investors’ misjudgement was to pay far too high a price for their insurance against future inflation.  Leveraged strategies, common in the private sector, compounded the problem.    

It was the re-setting of gilt yields to a normal level as QE came to an end that caused investors losses.  Liz Truss gets the blame, but it would have happened without her – her government was just the catalyst.  Today, with real yields at 2.5%, the argument that gilts will fail to provide protection is simply wrong.  Duration still has the capacity to result in substantial capital moves, both up or down, but if held to maturity, gilts present an attractive return profile for investments.

Gilts and diversification

Another popular meme a year or so ago was that gilts failed to provide any diversification benefit.  One of the arguments for buying gilts is that that they should provide some ballast when equities fall.  In the Global Financial Crisis, for example, they did so in spades, delivering a 12% return while equities fell by more than 25% in 2008.

In the environment of QE (2008-2020 approximately) all financial assets rose together.  Since then, bond prices have fallen while equity prices have largely risen.  Neither of those are counter-examples to the proposition that bonds can provide diversification when equities fall:  The real proof will be when equity markets endure a longer period of negative performance, perhaps because of economic recession or some form of financial crisis.

The pools are focusing on corporate and private credit

The final reason is much more LGPS specific.  The pools’ fixed income products almost all focus on corporate credit and not gilts.  I am aware that one pool has an Index Linked gilt fund, but I believe this is the only one.  This may be a legacy of the time when gilts yielded very little and the extra return from the credit spread was welcome, especially as low interest rates reduced default levels.   

However, today gilts must be the core of any fixed income strategy for pension funds with sterling liabilities.  So why are the pools’ offerings so focused on credit?  It seems to me that there is a large and obvious gap in their product line-up, and there will be a prize for the first pool to rectify this.