Mark Dampier: Skilful managers can combat inflation risks

The Analyst

The last few months have been uncomfortable for those like me who believe inflation is not yet a major problem. The headline rate has pushed ever higher. In my defence, much of this inflation has been down to VAT rises, as well as increases in non-discretionary items such as fuel, utilities and food. These are all essentials whose price hikes act more like an additional tax – one akin to putting up interest rates. Given this, I am not surprised the Bank of England has held off putting rates up. The recovery we are seeing is anaemic and any significant move would surely risk killing it off completely.

That said, there is no room for complacency. The vast quantity of money printing in the US and Japan, and last year in the UK, effectively means there is a lot more money in circulation than before. To date this money has largely been stuck with the banks, given their propensity to shore up their balance sheets and remain cautious on lending. So far it hasn't reached the consumer and affected inflation. However, at some stage it may do, so it is worth building some protection into your portfolio.

In my view, the best protection against inflation for the cautious investor is National Savings Index-Linked Savings Certificates. Sadly there are no issues on sale at present, and many of us wait with bated breath to see if any come out later this year. However, investors could consider the M&G UK Inflation Linked Corporate Bond Fund as a possible, though potentially higher risk, alternative. Launched in September 2010 and managed by two highly experienced fund managers, Jim Leaviss and Ben Lord, it is designed to protect investors from the ravages of inflation. It aims to do this by investing in a diversified portfolio of inflation-linked corporate bonds, index-linked gilts and floating rate notes (FRNs) which can protect investors against rises in interest rates. The fund can also invest in conventional corporate bonds and gilts if the managers believe these are where the best opportunities are to be found.

Some investors might consider buying individual index-linked gilts as a low-cost way of getting inflation protection. However, things can quickly get complicated. Most index-linked gilts are long dated, so they are very sensitive to interest rate rises – thus many can lose you money in the initial stages of monetary tightening. In 1994, for example, the Fed raised interest rates unexpectedly quickly to bring inflation under control and index-linked gilts suffered.

Shorter-dated gilts carryless risk in this regard, and thisis where the fund primarilyinvests currently.

Additionally, the fund managers have a number of other tools at their disposal to protect against rising interest rates. As well as shorting conventional bonds, they can buy derivatives that reduce the fund's sensitivity to interest rate movements, though it does relyon the skill of the managers toget their timing and stockselection right.

The market for index-linked bonds is large, with over £136bn of inflation-linked gilts and corporate bonds available in the UK. The opportunities are therefore diverse in terms of individual companies and industries. For example, the fund has stakes in bonds issued by Channel Tunnel Rail Link and a new issue from Bristol Water.Both are cash-generative businesses and the bonds provide anattractive yield.

Interestingly, the managers agree with me that inflation is not a major problem just yet. However, plenty of investors do fear it, which has meant significant demand for the types of investments owned by the fund. As such it has got off to a good start since launch. The income yield is currently quite small, but for those looking for an insurance policy against high inflation being a persistent issue it is certainly an investment to consider.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.h-l.co.uk/independent