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FEATURE: Julian Hofmann explains how to build yourself a portfolio of inflation-linked bonds

The surprise success of Adam Ferguson's When Money Dies: The Nightmare of the Weimar Collapse – first published during the stagflation quagmire of the mid-1970s but reissued in 2010 following word-of-mouth recommendations – underlines just how many people fear inflation.

Ironically, perhaps, the underground attention inflated the price of second-hand copies into four figures and briefly propelled Mr Ferguson out of a quiet retirement. But, if we are entering into a prolonged period of rising inflation – China again noted prices rising by more than 5 per cent a year last month – then index-linking a fixed-income portfolio to preserve capital after tax and inflation might be the best option for private investors, despite some real difficulties in entering the market and keeping track of prices.

Many market watchers can be forgiven for experiencing confusion in the past few months over whether inflation in the UK is a serious enough danger to trigger the process of reorganising a bond portfolio to take account of its corrosive effects.

The surprise fall in UK inflation of 0.4 per cent to 4 per cent in March was eventually pinned on food producers absorbing the cost of food price inflation. But, even when this is removed from calculations, the trend is still above the average of the past few years.

Andrew Sentance, the Bank of England's monetary policy committee's most committed inflation hawk, went on the record to say that sterling's recent weakness could soon push inflation above 5 per cent. If he is right, investors will have to start looking at index-linked bonds (or 'linkers') seriously as part of their anti-inflation strategies.

Risks and rewards

The benefits of linkers have been hotly debated, partly because in the UK they have only existed since the early 1980s so they have been seen as a more obscure asset class than traditional gilts and shares - in contrast to the long-standing Treasury inflation protected securities (TIPS) in the US. It also opens up the core debate about whether the purpose of investing is to make money, or simply to preserve one's capital in all situations and at all costs.

US value investor Jeremy Siegel is among the most vociferous critics of index-linked bonds. Siegel's main problem is the currently very low yield of most index-linked bonds as risk-averse investors have pushed up the price of bonds in the face of historically low central bank rates. He is worried that the currently negative yield will not offset the risk of rising interest rates as central banks come round to tackling inflation, setting up the possibility of large capital losses as yields accommodate the rate risk.

On the other side of the argument, there are unabashed fans of linkers, including influential bond fund manager Bill Gross of Pimco, who argues that we are entering a cycle of lower growth and consequently lower returns from all asset classes. The "new normal" as Mr Gross terms it, will force investors to conserve capital above all else in a world where making money will become increasingly difficult.

The UK market

It is important to bear in mind that the UK index-linked market is relatively illiquid compared with other types of bond markets. That's mostly because pension funds tend to buy them and keep them as a long-term inflation hedge as part of their regulatory requirement to meet all contingent liabilities, and they also have added value as tier 1 capital. In addition, linkers are popular because they track the retail prices index (RPI), rather than the consumer prices index (CPI) and so offer up to 0.6 percentage points of additional inflation protection.

However, the problem with some of the inflation-linked offerings in the retail bond market is that they are more like structured products, according to Henrietta Podd, head of Evolution Securities' fixed-income team, and this makes it very difficult for market makers to value and price them. "Some types of inflation-linked bond are rather esoteric – if a product has a floor or cap on inflation, it contains a derivative – this makes it much more difficult for anyone other than the person who wrote the initial contract to assess its basic value. This would apply to some of the bonds issued by banks that have a 'floor' on the coupon should inflation decline (a guaranteed minimum payout).

"What the market really needs is a simple and transparent product that you can buy at par on issue; that looks like an index-linked gilt but with extra inflation-protected return. That's why the National Savings certificates were so popular when inflation started to pick up."

Ms Podd pointed out that savers do have different options when it comes to an inflation hedge if the products on offer are too complex: "Apart from RPI-linked gilts, some banks offer accounts with inflation protection. National Counties offers an inflation-linked account and so does Birmingham Midshires. However, these offer no liquidity and if not in an individual savings account (Isa) or self-invested personal pension (Sipp) wrapper, they may not be very tax-efficient."

There could also be problems getting over the initial negative yields on what are currently highly priced individual instruments, but it is often possible for sophisticated investors to arbitrage the price of linkers. If a bond was issued on an inflation assumption of 3 per cent, but a few years down the line inflation is in fact 5 per cent, then the gain will offset the initial extra capital outlay.