Investors need to consider the impact than faster-than-expected inflation on their portfolios, according to Kames Capital, which is taking a closer look at index-linked bonds to help protect against this.
Much of the discussion in financial markets over 2015 centred on inflation – or more specifically the lack of it as plunging commodity prices and slowing demand in China threatened to push a wave of deflation around the globe.
Since the global financial crisis, inflation had remained stubbornly low but it has started to pick up more recently, with the US reporting that consumer prices rose by 0.4 per cent in April – up from a rise just 0.1 per cent in the previous month.
In the UK, the consumer prices index (CPI) hovered around 0 per cent for much of 2015 but rose to 0.5 per cent in March 2016. It recently fell back to 0.3 per cent, largely because of cheaper air fares after the Easter holidays, but economists expect it to be on a broadly upward trend by the end of the year.
UK CPI rate over 5yrs
Source: Office for National Statistics
Globally, most now expect inflation to start heading upwards but many experts stress that this is likely to be at a slow pace and say it will take several years before inflation moves back in line with official targets. In the UK, this target is around 2 per cent.
However, Kames Capital investment manager James Lynch argues that the market is being too sanguine about the outlook for inflation, which it appears to be basing on the past price falls in key commodity markets.
“I think the consensus view misjudges the future path of inflation,” he said.
“The effects of previous falls in the oil price are still being felt, with an outsized impact on headline rates of inflation and consequently on the market’s psyche. When these ‘base effects’ wash out, we believe that headline inflation rates will rise faster than the market currently expects.”
US headline inflation is currently at 1.1 per cent but the market is pricing in an average rate of 1.6 per cent over the coming 10 years. Meanwhile, eurozone inflation is at -0.2 per cent and the market is forecast that it will take five years at least before it passes 1 per cent.
But Lynch said: “Given that core inflation (which excludes volatile food and fuel costs) is currently 2.1 per cent, I think the market is being too complacent.”
“While I don’t think inflation is going to be a significant concern, my view leads us to favour the real yields offered by linkers over nominal bonds, which do not provide protection in an inflationary environment.”
The IA UK Index Linked Gilts sector has been the sixth best performing peer group over 2016 so far after posting a 6.46 per cent total return – although it is lagging the 7.42 per cent gain made by the average IA UK Gilts fund.
Performance of sectors during 2016
Source: FE Analytics
This is in contrast to 2015 when IA UK Index Linked Gilts ranked 31 out of 34 in the Investment Association universe with a 1.27 per cent loss. IA UK Gilts was in 27th place after falling 0.26 per cent.
The FE Research team has three funds from the IA UK Index Linked Gilts sector on the FE Invest Approved List: M&G Index-Linked Bond, L&G All Stocks Index Linked Gilt Index Trust and Vanguard UK Inflation Linked Gilt Index.
M&G Index-Linked Bond, which is managed by Ben Lord, is the only active offering on the list. The £347.9m fund was managed by Mike Riddell between 2010 and 2015, when he departed M&G; Lord took over in September 2015 and has M&G head of retail fixed interest Jim Leaviss as deputy on the portfolio.
The FE Research team points out that the fund has few periods of poor or outstanding relative performance in its history, as it has the aim of securing the value of income and protecting investors’ capital from inflation rather than beating its peers.
“The fund is conservative in its approach to investing. The managers aim to produce a return in line with the index-linked market and take little risk,” FE’s analysts said. “Investors should view the fund as a secure method of gaining exposure to UK government bonds without having to worry about the eroding impact of inflation on their value.”
When it comes to the index trackers, the FE Research team likes the simple approach taken by Legal and General Investment Management when it comes to passive investing and this means the full physical replication of an index whenever possible.
In the case of Vanguard, the group’s commitment to delivering low costs is highlighted. Unlike L&G All Stocks Index Linked Gilt Index Trust, the Vanguard UK Inflation Linked Gilt Index tracker uses sampled (rather than full) replication of the index, which adds the risk of the manager picking the right combination of bonds to mimic the index’s performance.
As the graph below shows, all three of the above funds have performed broadly in line with the market and their average peer over the past five years with M&G Index-Linked Bond edging slightly into the lead.
Performance of funds, sector and index over 5yrs
Source: FE Analytics
M&G Index-Linked Bond has a clean ongoing charges figure (OCF) of 0.56 per cent while both L&G All Stocks Index Linked Gilt Index Trust and Vanguard UK Inflation Linked Gilt Index charge 0.15 per cent.
