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Inflation-proof your income with linkers

FEATURE: Julian Hofmann explains how to use index-linked bonds (or 'linkers') to protect your income and names suitable investments.

Bonds or bond funds?

The main choice for investors who want diversification without the hassle of hunting and buying individual bonds is iShares' Index-linked ETF (TIDM: INXG), which purports to track the movements of index-linked gilts. As you'd expect, it is cheap to own – management fees are just 0.25 per cent – and easy to put in an Isa or Sipp. However, the use of funds divides opinion among fixed-income specialists.

The main problem, as many see it, is that the UK index-linked market is nowhere near efficient or liquid enough for trackers to accurately follow it. Additionally, investors have to take into account all sorts of anomalies; Evolution analysts point out that there have been several instances in recent years where redeemed bonds were still being given prices in the market simply because no one had checked their validity. In addition, even if fees are low, the cost still compares poorly with simply owning an individual bond and not taking the fee hit at all.

The other issue, which is probably more pertinent to actively managed corporate bond funds, is that investors have little real control over the asset allocation of a fund. When the credit crunch hit, many funds, with the exception of M&G's Corporate bond fund, were overexposed to banking bonds and consequently suffered large losses. An individual investor holding one or two bonds until redemption would never have been exposed to the same kind of asset risk.

Index-linked gilts
Bond nameISINTIDMSedolIssue dateMaturityCoupon premium vs RPI (%)Minimum pieceType
Treasury 0 5/8% Il Treasury 42GB00B3MYD345T42AB3MYD3424-Jul-0922-Nov-420.625£1Gilt
Treasury 1 1/4% Il Treasury 22/11/27GB00B128DH60T27B128DH626-Apr-0622-Nov-271.25£1Gilt
Treasury 1 1/4% Il Treasury 55GB00B0CNHZ09TR8FB0CNHZ023-Sep-0522-Nov-551.25£1Gilt
Treasury 1 1/4% Il Treasury Gilt 17GB00B0V3WQ75T17B0V3WQ708-Feb-0622-Nov-171.25£1Gilt
Treasury 1 1/4% Il Treasury Gilt 32GB00B3D4VD98T32B3D4VD929-Oct-0822-Nov-321.25£1Gilt
Treasury 1 1/8% Il Treasury Gilt 22/11/37Gb00b1l6w962Tr37B1l6w9621-Feb-0722-Nov-371.125£1Gilt
Treasury 1 7/8% Il Treasury Gilt 22/11/22Gb00b1z5hq14T22B1z5hq111-Jul-0722-Nov-221.875£1Gilt
Treasury 2 1/2% Il Treasury 11Gb0009063578Tr2h90635728-Jan-8223-Aug-112.5£1Gilt
Treasury 2 1/2% Il Treasury 16Gb0009075325Tr1690753219-Jan-8326-Jul-162.5£1Gilt
Treasury 2 1/2% Il Treasury 20Gb0009081828T2hi90818212-Oct-8316-Apr-202.5£1Gilt
Treasury 2% Il Treasury 35Gb0031790826T2il317908211-Jul-0226-Jan-352£1Gilt
Treasury 3/4% Il Treasury Gilt 22/11/47Gb00b24ffm16T47B24ffm121-Nov-0722-Nov-470.75£1Gilt
Treasury 4 1/8% Il Treasury 30Gb0008932666T30i89326612-Jun-9222-Jul-304.125£1Gilt
Treasury Tr.2 1/2% Il 24Gb0008983024T24i89830230-Dec-8617-Jul-242.5£1Gilt
Treasury Tr.2 1/2%Il 13Gb0009036715T13i90367121-Feb-8516-Aug-132.5£1Gilt

Tips for buying linkers

The best tip is to look for index-linked bonds with relatively short redemption dates if you are worried about inflation over a three- to five-year period. These don't tend to interest pension funds as they have to plan for the long-term effect of inflation on their investments and are consequently often much cheaper.

There are linkers on the market that are short enough to be good value but still long enough to be eligible for Isas and Sipps. The Bankers Investment Trust 10.5%, for example has an expiry date of 31/10/16 and currently trades at around 125p. The European Investment Bank 1.65% 26/07/2016 also seems good value at a clean price of 129p. However, your broker will have to work hard to get hold of these and the likely minimum denomination of £50,000 will be prohibitive, in which case the linkers listed in the table below are readily available on the London Stock Exchange's retail bond market and trade in more realistic denominations.

These gilts offer both coupon and redemption prices linked to RPI and are easy to understand. Remember also with index-linked gilts that the main return is the gain in capital after a fixed amount of time, which as they are gilts is entirely tax free.

The LSE's Order Book for Retail Bonds (Orb) is less well served by corporate bonds that carry inflation protection (see table below). Royal Bank of Scotland's floating rate bond currently has an uplift facility in the coupon that keeps it ahead of RPI, although the same does not apply to the capital.

Index-linked corporate bonds

Bond nameISINTIDMSedolIssue dateMaturityCoupon valueCoupon typeMinimum piece (£1)Type
Royal Bank Of Scotland Plc 2% Pp Fltg Rte Nts 07/03/2017Gb00b42sh312RbrpB42sh3121-Feb-1107-Mar-172Variable100Corporate Bond
Royal Bank Of Scotland Plc Pp Floored Fltg Rte Nts 06/12/20Gb00b4mts317RbpxB4mts3106-Dec-1006-Dec-208Variable100Corporate Bond
Royal Bank Of Scotland Plc Pp Flrd Fltg Nts 01/11/22Gb00b4rm3t66RbliB4rm3t601-Nov-1001-Nov-223.9Variable100Corporate Bond
Royal Bank Of Scotland Plc Pp Inf Lkd Nts 01/11/22Gb00b4p95l57RbpiB4p95l501-Nov-1001-Nov-223.9Variable100Corporate Bond

The fund manager's perspective

The isn't much that C&G Asset Management's Peter Spiller hasn't seen in a City career spanning four decades at some of its most prestigious institutions. However, after living through the upheavals of exchange controls, the 'big bang' and numerous asset and stock market bubbles, he is particularly worried by the current debt and inflationary situation, and the alleged complicity of parts of the UK’s economic establishment in creating it.

He certainly isn't afraid of getting straight to the point when it comes to saying what he thinks of them: "I will paraphrase their arguments thus: 'There is no repayment problem because the government proposes to defraud the people who finance its debt.' That is a quite a good description of the inflation policy of many countries in the 20th century, so the starting point for anyone wanting to make an investment is not to be one of those defrauded."

For Mr Spiller, there is only one defence in the great inflation war: index-linked securities should play the major role in an investor’s armoury, even if, currently, real yields on index-linked bonds are negative.

"It is natural that investors want to make money, but the priority at the moment should be to preserve capital after tax and inflation."

The problem, as he sees it, is that almost all asset classes are feeling the effect of inflation expectations: "Shares are rated at well above their historic average and that is being driven by the hunt for yield. A Merrill Lynch survey recently showed that the percentage of cash in institutional portfolios had fallen to an all-time low of 3 per cent." That wall of liquidity leaves investors with few really good value investment options, in Mr Spiller's view.

Peter Spiller

"In the 1970s, we had 'Granny bonds' from the post office that paid out your capital adjusted for inflation after a certain number of years. The popularity of those at the time meant you had to be over 65 to own them, which shows that had index-linked securities existed at the time they would probably also have had negative yields."

But isn't saying that yields don't matter a bit counter intuitive? I venture. "Perhaps, but when you look at linkers you've got to take a long-term view. In the first two years you effectively pay to hold the security after tax on income is deducted, but after that point the compounding effect starts to kick in and the returns progressively increase."

Then what about gold as a hedge? I ask. "I have a lot of respect for people who argue that gold is still a store of value, but the problem is that it is too volatile an asset class since Nixon removed the money link 39 years ago."

The basic facts bear Mr Spiller's point out. Prices have ranged from the $850-an-oz real-terms high in 1980 to what he calls the "Gordon Brown low" of $250 an oz, with inflation over that period of about 50 per cent. "Fundamentally, gold is useless at storing value at a time of moderate inflation, but it comes into its own when people think they will lose everything. A political crisis in China might persuade more people to hold assets in gold, for example."

So it is a catastrophe asset, then? "That's your quote, not mine, but linkers can perform the role in a portfolio that gold always used to, which is to preserve the basic buying power of money," he said. For UK investors, holding index-linked gilts or the few linked corporate bonds on the open market is a realistic starting point, as Mr Spiller says that holding them through a fund is uneconomic because the tax rate becomes an issue.