Fight inflation strategically

Inflation is the mortal enemy of fixed-income investments, and it is on the warpath. Consumer price inflation is running at 4.5 per cent and retail prices are rising at 5.2 per cent a year. Yet the standard investor weapons against inflation - property, commodities and shares - may not appeal to those for whom capital preservation is a priority. Index-linked gilts are expensive. One alternative is a strategic bond fund - and Henderson offers one of the best.

The key attraction of strategic bond funds is flexibility. They may invest in any kind of bonds the fund manager chooses as long as they are sterling denominated or hedged against sterling, in contrast to other types of bond fund that must invest at least 80 per cent of their assets in one type of bond.

At present, many strategic bond fund are holding high-yield bonds to help them stay ahead of inflation but will be able to reallocate when high-yield bonds are no longer attractive investments.

Strategic bond funds can also easily switch the average duration of their underlying holdings to address interest-rate risk. Although it's expressed in years, duration is a measure of a bond's sensitivity to interest-rate movements. A five-year duration means a bond will decrease in value by 5 per cent if interest rates rise 1 per cent and increase in value by 5 per cent if interest rates fall by 1 per cent.

Henderson Strategic Bond Fund offers a yield of 6.8 per cent, one of the highest in the sector. It has posted robust long-term total returns and is one of the top five funds in its sector over five years. From its launch until the end of 2010 the fund returned 51.7 per cent against 33.5 per cent for the average strategic bond fund.

The fund aims provide a total return rather than focus on income, and so also offers growth potential. It is managed by fixed income veteran John Patullo, who is also Henderson's head of retail fixed income. He has worked at Henderson since 1997, and was a chartered accountant for four years before he became a fund manager.

According to Mr Patullo, the fund is using instruments other than expensive index-linked gilts to protect itself against the onslaught of inflation. These include interest rate swaps and futures. The fund also uses derivatives to enhance returns and protect capital and credit default swaps to guard against default risk.

The fund's managers incorporate analysis of trends and relationships between economic and market variables to help put global events into context before considering their allocation and stock selection, and also draw on the views of Henderson's in-house strategy and fixed-income teams.

Strategic bond funds may not be suitable for very cautious investors because they may take positions in higher-risk, higher-return assets, and because their profiles change frequently. Their short-term volatility can also be quite high, so they should ideally be held for longer periods.

Key fund data:

Source: Investors Chronicle & *Henderson

Performance data as at 26 May 2011

Top ten holdings:

Bond breakdown: