If you want to buy bonds which have built-in inflation protection you have a couple of choices I have you by the individual bonds directly or you can buy a pool of the bonds wrapped up inside a fund each of the two methods has its drawbacks and benefits so here we look at some of those practicalities in detail bear in mind all of these examples are just illustrative if you want to investment advice go and see your independent financial advisor in our inflation video we look to see which of the asset classes provide some degree of protection against rising inflation bonds don't because their income is fixed an inflation is the mortal enemy of bonds gold was simply not reliable its historic returns just aren't linked to inflation shares provide a bit of protection but once inflation reaches about full percent all of that protection disappears the only asset class where there's a reliable link between its returns and inflation is inflation linked bonds I use an application called share scope to look at share prices and bond prices I've done a simple search for index-linked Treasuries here's a list of 28 of them if you want to search for these on your broker's website you can use these codes on the Left I've highlighted Road 14 and the identify there is trt q the bond was born or issued in 2011 and it dies or matures in 2034 and the price is about a hundred and forty eight pounds so I went to my broker's website in this case Barclays I look up TR T Q and the buy price is a hundred and forty-nine I click on deal and oops I get a message saying this stock cannot be traded online please phone us to place an order so these are the two problems the trading sizes are big well if I couldn't afford a hundred fifty pounds share prices tend to be much smaller the second problem is that for small investors such as myself index-linked bonds are harder to trade they're less liquid than shares liquidity remember is how quickly you can buy and sell an asset if I had millions of pounds to invest inflation linked bonds would be very liquid but not for the little guy this is why we might want to think about an alternative which is an inflation linked fund a fund is just a managed pool of investments that can be actively managed we're a highly skilled fund manager selects individual assets to buy and sell but what we consider here a passive funds which tend to be cheaper funds are great because they provide access to a wide range of markets these can be shares bonds commodities or a whole pool of assets mixed up together good multi-asset funds the second benefit which is very pertinent here is liquidity funds traded quickly easily and cheaply because we're buying a pool of asset we get a degree of diversification but in this case that's not particularly relevant buying a very liquid fund can also reduce costs we're also buying the expertise of the fund manager funds come in many flavors here we're going to consider exchange-traded funds remember this is just illustrative and not expressing a preference for one type of fund over another in the UK your choices are fairly limited there are three main inflation linked exchange-traded funds they called exchange-traded because you buy and sell them just like a stock which means that while markets are open you just look up the ticker which I've shown here in red i NX g g IL i and x g IG and then you just click on buy or sell just as if it was a single stock phi NX g and g ili are both linked to UK gilts the third one is a global pool of inflation linked bonds not just from the UK but also from the US and europe whenever you buy a fund it's always worth looking at the total expense ratio or te r if you buy a hundred pounds worth of i NX g the expense ratio is percent which means that you'd pay 25 pence a year to the fund manager which is Blackrock G IL I only has an expense ratio of 0.7% so you'd only pay them 7 pence a year on your hundred pound investment we can look at the fact sheet again purely for illustrative purposes in this case we'll look at INX G you can download a description of the fund from the iShares website for example we can see that it passively cracks the Bloomberg Barclays UK government inflation linked bond index well that's good because we want to track index-linked bonds the ongoing expenses are just point two five percent of the capital invested income has paid to you two times per year and it's reassuring to see that the size of the fund is considerable it's almost a billion pounds and of course is popular for a reason we can also see the top holdings in the bottom right in other words of the bonds in which that 1 billion pounds is invested in the bottom left you can see how closely the fund has managed to track its benchmark usually it's within point 1 percent each year ideally we'd run that tracking error to be 0 to show the benefits of inflation protection we can take two very similar funds the fund manager is the same Blackrock both are based on UK government bonds but the one on the left is not linked to inflation the one on the right I on X G as we've seen is linked to inflation the colored boxes represent which risks we're taking with each of the two different funds I've shown four of the risks here and because the contents of the funds are so similar they share three of those risks but the difference between the two is the inflation risk risk and return are related so very roughly we could say that the only difference between the returns should be compensation for taking UK inflation risk let's see how much that pays this would be the value of 1000 pounds invested in 2007 the red line is the inflation linked fund the blue line is the gilt fund which is not inflation linked in the panel below I've shown the level of inflation you're on yeah for the UK hopefully what you can see is that when inflation is high such as in 2009 and again around 2012 the red line starts to move up above the blue line as the inflation protection pushes up the values of those index-linked bonds conversely when inflation is very low such as in 2015 gilts will outperform of course what's really interesting is that most recently in 2016 we've started to see those inflationary pressures rise again and as a result the index-linked fund has outperformed again it always pays to look at the risks on the cheat a key one here is that if we get deflation there's no protection of your principle in other words if inflation goes into reverse and you get deflation where the prices of goods and services is falling then you can make a capital loss on your linkers and on your fund and also in the small print you can see that the credit rating of the UK may adversely affect the price of the fund but surely the UK would never get downgraded well actually yes it could this was a story in the FT as recently as January the 18th talking about the effect of brexit uncertainty on the credit rating of the UK and this is seen as a very material risk by many of the rating agencies so this is something which you should be aware of and finally a reiteration of the legal bit this is not a recommendation but if you found this interesting you could seek independent financial advice and I'm sure your IFA would love to discuss this with you in more detail. |
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