The millionaire's option

The accountancy firm of Binder Hamlyn is used to meeting newly- created millionaires, or those who are nearly so. Over the last year it has advised dozens of National Lottery winners on how to invest their windfalls. The firm's recommendations naturally depend on the size of the winnings, and the lucky winner's attitude to risk.

They usually recommend that a portion of the money is invested in index- linked gilts (ILGs) to conserve the real value of the capital. Just like conventional gilts, ILGs are issued by the British government; the difference is that both the regular interest payments and the capital repayment on redemption are adjusted in line with inflation.

Although ILGs have been available to private investors since 1982, they remain a mystery to many people. The principle of the income they pay, and the capital, being linked to the Retail Price Index (RPI) is simple enough. However, as the rate of inflation is an unknown variable, in practice ILGs are complex securities.

Let us say that an ILG is issued at the beginning of year 1 with a coupon rate of 2.5 per cent. Suppose that the stock is to be redeemed at the end of 10 years, and that during the life of the stock, the RPI increases by 40 per cent.

At the end of year 10, an investor will receive pounds 140 for every pounds 100 invested. Over the life of the stock, the regular dividend will have increased from 2.5 per cent to 3.5 per cent - simply a 40 per cent increase on the 2.5 per cent coupon.

This theoretical example is an oversimplification, as in practice the index-linking lags eight months behind the RPI. However, it demonstrates the general principle.

Although the interest paid is index-linked every six months, the capital element is not adjusted for inflation until the stock's redemption date. Just as with conventional gilts, the price of ILGs fluctuate in the market, their price being determined by the supply of and demand for the stocks. With ILGs, this is driven by the market's changing perceptions of inflation and real yields.

Therefore, anyone buying ILGs who sells them before the stock is redeemed, could lose a portion of their original capital. Nevertheless, historically ILGs are less volatile than traditional gilts. "Short" dated ILGs - ie those with a life of up to five years - fluctuate less than their counterparts with longer redemption dates. However, investors who stay the course have the security of knowing that the real value of their capital will be maintained, as well as the comfort that the regular income derived from the stock will keep pace with inflation.

If you look at the price of ILGs on the market report/shares page of The Independent, you will see that a redemption yield is given for the 12 stocks quoted.

This is the real gross yield to redemption, assuming that the rate of inflation is 5 per cent. In other words, it is the aggregate of all future interest dividends and the capital gain at redemption, annualised in real terms - ie the real yield, less the assumed rate of inflation.

David Wells of Binder Hamlyn gives an example of the kind of return an investor could expect from putting pounds 100,000 into ILGS. He selects Treasury 2.5 per cent 2011, which was issued on 28 January 1982, as an example. On the day in question it was quoted at pounds 183 and, assuming a 5 per cent inflation rate, had a gross redemption yield of 3.3 per cent.

"At today's price an investment of pounds 100,000 would secure a stock with a nominal value of pounds 54,645," explains Mr Wells (pounds l00,000 minus pounds 183). "Currently such a holding would produce an income of pounds 2,808.74 a year. Over the years the income would increase with the RPI. At the redemption of the stock in 2011, the investor would receive the nominal value of the stock, adjusted to take account of the increase in the RPI since the stock was issued. In this case, the growth of the capital would be about 0.5 per cent a year above the rate of inflation."

So who, apart from National Lottery winners, invests in ILGS? It is estimated that 80 per cent of the market value of ILGs is held by institutions. Personal investors tend to buy shorter dated stocks, while pension funds and life companies dominate the market for longer dated ILGS.

As Binder Hamlyn is the first to admit, ILGs should form only a part of a personal investor's portfolio. They are suitable for wealthier individuals seeking capital security with the added bonus of a return above the rate of inflation. They are also a tax-efficient investment, as the capital gain is not subject to capital gains tax. Anyone considering investing in ILGs should certainly consult their financial adviser before taking the plunge