Inside the Yield
Expected inflation
Inflation is the rate at which prices for goods and services rise over time. A pound in 5 years will not buy as much as a pound today. It means that although the future cashflows from a gilt may be fixed, the real value of those flows depends on future inflation, which is not fixed. Therefore inflation, or more accurately inflation expectations, are critical to understanding gilt yields.
Gilt Yield incorporates expected inflation
A conventional gilt states its coupons and its repayment in pounds. Those pounds do not grow when prices rise. The buyer who accepts the yield has already allowed for some path of inflation over the life of the gilt. The yield is the compensation for lending the pounds, and that allowance is part of the compensation.
Take £100 due in ten years, the sort of cashflow waiting at the end of a gilt. If we assume we have inflation at the 2% target for the decade, and the £100 buys about £82 of today's basket. If inflation is 4% it buys about £68.
Clearly, to buy a gilt, we must expect to receive back more than we paid in real terms. This is why inflation is so important to the gilt market, and great effort is put into correctly predicting future inflation. As we can see below, getting this called wrong is costly.
Over the allowance, or under it
Experiment with the sliders below to get a feel for how inflation affects the real value of money over various time periods. The bars open on that ten-year example: 2% allowed for, 4% arriving. The first slider is the inflation allowed for when the price is struck. The second is the inflation that arrives. Years is how long the £100 waits. Drag the second slider under the first, or stretch the years, and the same cheque buys a different basket.
An index-linked gilt moves the inflation into the cashflow instead. The coupon and the principal rise with RPI, which is why the linker beside the conventional gilt on The Gilt is quoted as a real coupon, paid uplifted with RPI. The buyer of a conventional gilt has to be paid for inflation inside the yield. What CPI and RPI actually measure is on CPI/RPI.
There are different methods that the government measures inflation, with significant effects. Understanding that inflation is a general rise in the price level is sufficient for now, but more detail read CPI/RPI.
Inflation risk premium
The breakeven is the nominal spot yield minus the real spot yield. It compensates for the Retail Prices Index, so it is not a CPI forecast. Expected inflation, above, is an assumed path, not that breakeven. The inflation risk premium is the breakeven minus the path. It is the extra inflation compensation further along the curve, and it rises with maturity.
Setting the 2.5-year breakeven equal to expected inflation forces the premium to about zero at the short end of the real curve. That is a choice, made so the split has an anchor. At three years the premium sits just below zero, and passes through about zero there. Further out, the breakeven is higher than the path, and the difference is this slice.
Call the whole breakeven expected inflation instead, and this slice moves into that piece, with the real-rate term premium rising by the same amount. The prices alone do not say which labelling is right.
The yield is comprised of more than these two inflation pieces. The next piece is the expected real rate: the expected path of short rates once this inflation path is taken out.