Richard Troue: Retired are hit hardest by toxic mix of inflation and low interest rates
Friday 17 May 2013
Most of the industrialised world is enduring interest rates which are persistently lower than the rate of inflation. This has occurred before – most notably when inflation was running at 25 per cent in the mid-1970s.
There are implications for savers, and especially for people who depend on their savings for income. The problem is aggravated for the retired, as their personal rate of inflation is probably greater than the published figure. Official figures take into account many items which have come down in price but which are discretionary purchases, such as computers and other hi-tech gadgetry.
On the other hand essentials – food, power, water, council taxes, etc – are all increasing in price, meaning retired people on fixed pensions or dependent on income from their investment capital are the hardest hit by the current situation.
Furthermore, the change to the Bank of England's remit could have long-term consequences. The Bank is still required to target an inflation rate of 2 per cent, but the change allows it to "look through" the inflation figures and target other variables, such as economic growth. This is a signal that the Government is prepared to tolerate higher inflation in exchange for a faster recovery.
I don't see the toxic combination of inflation and low interest rates coming to an end soon. Those with debt (such as the Government) will benefit, as they continue to borrow cheaply while higher inflation erodes the value of their debt. Meanwhile savers are seeing the purchasing power of their capital chipped away.
In their search for inflation-beating returns many investors have turned to the stock market. However, for most investors having all their capital in the stock market is not prudent. Fortunately there are options which exhibit lower volatility.
Traditionally corporate bonds have been a good choice for investors who want a better return than available on cash, but with less risk than the stock market. Unlike shares, with corporate bonds you are simply lending a company money, in return for which it should pay you an annual rate of interest. As long as the company remains solvent it pay the interest and when the bond matures repay the initial sum loaned.
The trouble with corporate bonds is that the income they pay, and their capital, are often fixed, so they offer no shelter against inflation. However, some companies and governments issue index-linked bonds, where the value of any income paid and the capital repaid at redemption increase annually in line with inflation.
These are exactly the types of bonds the M&G UK Inflation Linked Corporate Bond Fund targets. It aims to provide a return above the rate of inflation over the long term by investing partly in a portfolio of index-linked UK government and corporate bonds. In addition, the managers use derivatives to add an element of inflation-linking to their corporate exposure. Derivatives are also used to reduce the sensitivity of the fund to rising inflation or interest rates.
The result is a portfolio which should appeal to more cautious investors. It doesn't offer the potential for significant gains, but since launch in September 2010 it has maintained the purchasing power of investors' capital, growing by 12.5 per cent compared with a rise of 9.3 per cent for the consumer price index. It has achieved this with little volatility, particularly when compared with the stock market. Investors should also remember that if they buy this fund in a stocks and shares Isa there is no tax to pay on any growth or income.
The fund is managed by the experienced duo of Jim Leaviss and Ben Lord, who believe that central banks will continue to tolerate higher inflation. They are concentrating on inflation-linked bonds issued by large, stable companies, as they believe the yields offered by index-linked government bonds have fallen too low. The active use of derivatives, though, introduces risks not present with more traditionally managed funds.
This fund could be considered by investors who wish to protect the spending power of their capital against inflation, but who wish to take a more cautious approach. It could also be used to diversify and reduce the volatility of a more equity-focused portfolio.
Richard Troue is an analyst at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit hl.co.uk/independent
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