Inflation-linked gilt funds still have an important role to play in investors’ portfolios, despite the current low yields on standard UK Government bonds, according to Investec’s Darren Ruane.

Inflation remains a drag on overall returns as the Bank of England refuses to budge on interest rates until the economy is in better shape. Moreover, economists believe inflation is likely to remain well above the Bank's 2 per cent target for the remainder of 2012.

However Ruane, senior bond strategist at Investec, says this backdrop underlines the value of holding expensive gilts.

"Investors generally want to achieve returns greater than inflation over the life of an investment and real returns from inflation-linked gilts are currently negative. In addition, at some point real Government bond yields could adjust to rates of maybe 2 to 3 per cent once the economic cycle has normalised," he commented.

"However, inflation-linked gilts play an important role as insurance. In a diversified portfolio, they provide protection against the potential for higher inflation over the long-term and it is unlikely that real yields will rise materially in the short-term."

According to data from FE Analytics, the average Index-Linked Gilts fund has returned 52.62 per cent over the last five years, outperforming the consumer price index as well as the paltry 0.6 per cent return from the average UK All Companies portfolio.

Performance of sectors vs CPI over 5-yrs



Source: FE Analytics

According to Investec, over the longer term there are many reasons to suggest that inflation could be higher than history has witnessed over the past 15 years.

For example, the group said that in an environment where sovereigns are struggling to pay off debt, high inflation could ease the burden of paying back creditors. Also, inflation is a natural by-product of central banks' continued policy of weakening currency through quantitative easing.