If you want to buy bonds which have built-in
inflation protection you have a couple of
choices. Either you buy 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 investment advice
go and see your independent financial advisor.
In our inflation video we looked to see which
of the asset classes provide some degree of
protection against rising inflation. Bonds
don't because their income is fixed and 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
4% 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 ShareScope 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 row 14 and the identifier there
is TRTQ.
The bond was born, or issued, in 2011 and
it dies, or matures in 2034. And the price
is about £148.
So I went to my broker's website, in this
case Barclay's, I look up TRTQ and the buy
price is £149.24.
I click on deal and... ooops! 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. What if I couldn't
afford £150?
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.
This can be actively managed, where a highly-skilled
fund manager selects individual assets to
buy and sell, but what we consider here are
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 called multi-asset funds.
The second benefit, which is very pertinent
here, is liquidity: funds traded quickly,
easily and cheaply.
Because we are buying a pool of assets 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 flavours. Here we're going
to consider exchange-traded funds. Remember
this 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 are 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: INXG, GILI and XGIG and
then you just click on "Buy" or "Sell" just
as if it was a single stock.
INXG and GILI 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 TER.
If you buy £100 worth of INXG the expense
ratio is 0.25% which means that you'd pay
25 pence a year to the fund manager, which
is Blackrock.
GILI only has an expense ratio of 0.07%, so
you'd only pay them 7 pence a year on your
£100 investment.
We can look at the fact sheet, again, purely
for illustrative purposes. In this case, we'll
look at INXG.
You can download a description of the fund
from the iShares website. For example, we
can see that it passively tracks the "Bloomberg
Barclays UK Government Inflation-Linked Bond
Index". Well, that's good, because want to
track index-linked bonds.
The ongoing expenses are just 0.25% of the
capital invested. Income is 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,
it's popular for a reason!
We can also see the top holdings in the bottom
right, in other words, the bonds in which
that one 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 0.1% each year. Ideally,
we'd want that tracking error to be zero.
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, INXG, as we've seen, is linked
to inflation.
The coloured 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 one thousand 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 year-on-year
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 inflation-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
fact sheet.
A key one here is that if we get deflation
there's no protection of your principal. 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 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 re-iteration 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.
