Are linkers a good deal for taxpayers?

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An index-linked gilt – known as a linker in City speak – is a government IOU whose principal and interest payments rise with the Retail Prices Index (RPI). Inflation erodes the value of an ordinary bond; a linker compensates the holder for it.

The post-Covid inflation shock showed why anybody would want one. Inflation, thought to have been buried with the economic disasters of the 1970s, roared back to life. Pension funds and insurers holding linkers were shielded against much of the inflation risk in the benefits they had promised to pay.

And while the case for investors was an easy one, for the taxpayer on the other side of the contract, rather less so. Britain has sold inflation insurance on a larger scale than any other G7 economy. The policy paid out, but that doesn’t make it a bad policy. The question is whether governments charged enough for bearing the risk.

Back in March 1981, Geoffrey Howe was dealing with a gilt market battered by a decade of inflation. Anyone lending to the British state for 20 or 30 years knew that ministers could repay the debt in money worth considerably less than when it had been borrowed. Conventional gilt yields contained a hefty premium for that risk.

Pension funds had the opposite problem. They had promised benefits for decades to come, many tied directly or indirectly to inflation, but had few assets that rose with those liabilities. Linkers united the two sides. The pension schemes were protected, and the Treasury secured a reliable source of long-term finance and expected to pay a lower real yield in return.

There was a political benefit too. A government claiming to have broken with the inflationary habits of the 1970s was putting its money where its mouth was. Ministers could still allow inflation to rise, but they could no longer use it to reduce the real value of this part of the national debt.

Defined-benefit schemes were pushed by regulation and accounting rules to match their assets more closely with their liabilities. Liability-driven investment took them deeper into long-dated gilts, linkers, swaps and repo – repurchase agreements used to borrow cash or gilts short-term. 

For the Treasury, this was an unusually attractive market. Pension funds were large, predictable and far less sensitive to price than an investor free to move elsewhere. At the extremes they accepted deeply negative real yields, knowingly lending to the Government at less than inflation because the bond solved a more important problem elsewhere on their balance sheet. The Debt Management Office (DMO) estimates that linkers which had matured by March 2026 saved the Exchequer £86.9 billion, valued at maturity, compared with equivalent conventional gilts.

Whether newly issued linkers offer the same value is a different question. Most private-sector defined-benefit schemes are now closed to new members. Many have moved into surplus as higher interest rates reduced the present value of their liabilities. Some will continue to run; others will transfer their obligations to insurers through bulk-annuity deals. The pension promises remain, often for decades, but the behaviour of the buyer changes.

However, demand is hardly about to disappear. The DMO’s £4.75 billion reopening of the 2038 linker on July 14, 2026 was strongly supported, with domestic investors taking 89% of the allocation. Buyers can plainly still be found. What matters is the price at which they appear. As the old pension-fund bid becomes less dominant, the marginal investor has more freedom to walk away. An insurer can buy infrastructure debt. An asset manager can choose corporate credit. An overseas fund can move into another sovereign market. And hedge funds can reverse course in an afternoon.

The Treasury has noticed the change. Linkers account for 9.3% of planned gilt sales in 2026-7. The DMO reports weaker defined-benefit demand at longer maturities and says some market participants believe pension-fund demand for linkers has recently declined. Issuance is already being tilted away from the old model. The stock accumulated under that model is another matter. Britain entered 2026 with £688.5 billion of index-linked debt outstanding on an inflation-uplifted basis, equivalent to 25.2% of the wholesale portfolio and roughly twice the share of the next most exposed G7 economy.

Nor does that exposure sit alone. Many pensions and benefits are uprated with inflation, while public-sector pay and procurement costs tend to follow with a lag. Quantitative easing left hundreds of billions of pounds of reserves paying Bank Rate. When inflation and interest rates rose together, the Exchequer was exposed on both fronts. RPI increased the accrued principal on linkers, while higher Bank Rate fed almost immediately into the interest paid on reserves. Most of the inflation uplift on principal is paid only when the bond matures; reserve interest is a current cash cost. In reality, Britain had tied a large part of the public balance sheet either to inflation or to overnight interest rates.

None of this makes linkers a failed instrument. They remain useful, pension funds and insurers still need them, and abandoning a large and liquid market would be perverse. The question is one of scale and price. Historical savings and a heavily subscribed syndication do not, by themselves, show that issuing another linker represents good value.

The Treasury does publish a break-even calculation. Its latest analysis concludes that linkers are cheaper than equivalent conventional gilts if RPI averages no more than 3% over their lives. What it does not show with the same clarity is how another pound of inflation-linked debt affects the risk of the public balance sheet once tax receipts, indexed spending and remunerated reserves are included.

Covid proved the value of linkers to investors. It also exposed the size of the insurance policy written by the British taxpayer. The Treasury should publish a forward-looking assessment of the risk to show why the current scale still makes sense.

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