Bond navigators: understanding what drives index linked bonds

There is a question many fixed income investors ask: If inflation has remained relatively sticky, why have index linked bonds struggled at times? The answer is that index linked bonds are not just driven by inflation, but by two forces working together: real yields and inflation expectations. This is why index linked bond moves can sometimes feel counterintuitive. Understanding that interaction of these two forces is key to making sense of recent performance, and more importantly, where the opportunity lies from here.

The first driver is real yields, and this is the dominant force. When real yields rise, index linked bond prices fall, and the impact is significantly larger for longer-dated bonds given their higher sensitivity to interest rates. This is why periods of elevated or rising real yields can lead to meaningful drawdowns, even in an environment where inflation remains high. The second driver is inflation expectations, often referred to as breakevens. This is what differentiates index linked bonds from nominal bonds. If nominal yields rise, but inflation expectations rise by a similar amount, real yields may not move materially, and index linked bonds can hold their value much better in relative terms.

Where we are today is quite unusual, in that both nominal yields and real yields are already elevated, reflecting a market that is still anchored to a ‘higher for longer’ policy backdrop. From here, there are two clear paths. If inflation remains sticky, nominal yields could continue to drift higher, but inflation expectations may rise alongside them, limiting further increases in real yields. Alternatively, if we see a more meaningful disinflationary impulse, for example, through easing geopolitical pressures, nominal yields are likely to fall. Even if inflation expectations fall as well, the key dynamic is that real yields would decline, which tends to be the primary driver of positive returns for index linked bonds.

After a prolonged period where higher real yields have weighed on performance, markets are now priced at levels where the asymmetry is shifting.

This is where the current opportunity starts to emerge. After a prolonged period where higher real yields have weighed on performance, we believe that markets are now priced at levels where the asymmetry is shifting. It arguably takes less to drive real yields lower than higher from here, particularly if growth begins to soften or policy expectations are revised. In our view, that means the return profile for index linked bonds is increasingly tied to whether we move into a phase where real rates can normalise lower, rather than inflation needing to surprise further to the upside.

That brings us to how to benefit from such a move. Not all index linked bonds behave the same. Shorter-dated strategies tend to be driven more by realised inflation and are typically more stable, with less sensitivity to changes in real yields. Longer-dated index linked bonds, by contrast, are much more exposed to shifts in interest rate expectations and forward-looking inflation dynamics, which makes them more volatile, but also offers greater upside if real yields fall.

Positioning in our UK index linked bond funds has therefore become more selective. We have retained a long-end bias but trimmed exposure and reduced duration, taking profits on nominal gilts after strong front-end performance, while increasing our focus on UK index linked bonds.

This difference is clear in the performance of the funds over the past year. As chart 1 below shows, longer duration index linked bond funds have been more exposed to interest rate and real yield movements, leading to larger swings in returns. Shorter duration strategies, by contrast, have provided a steadier return profile, with more consistent inflation protection given their lower sensitivity to real yields and reduced exposure to long-end volatility.

Chart 1: Longer duration has been more volatile over the past year

Source: RLAM as at 19/06/2026. Past performance is not a guide to future performance. Capital at risk. 

In the current environment, an allocation to real yield strategies can provide a useful hedge, particularly if the next move in markets is characterised by moderating growth and a gradual decline in interest rate expectations over time.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.