For investors, 72 is a magical number. Divide it by the rate of return you are getting on your investment and it will tell you how many years it will take to double in value. Divide it by the rate of inflation and it will tell you how many years it will take your savings to halve in real terms.
The National Institute of Economic and Social Research says inflation in the UK will hit around 5% next year. The average cash ISA pays 0.3% in interest. At these rates your money will halve in value in just over 15 years.
If you are retiring today at 65, can you afford for this element of your savings to halve by the time you are 80?
Cash has a part to play in an investment strategy, but are too many of us holding too much? Of the £584bn in ISAs, around half is in cash.
Unfortunately, it’s impossible to say how much self-invested personal pension money is on the sidelines – that’s the place where cash arguably offers the least benefit to most people because, unless you’re retired, you can’t use it as an emergency source of income.
Traditionally investors have put the bulk of their long-term investments beyond cash into bonds. But many are concerned that, thanks to quantitative easing, fixed income and equities have become correlated.
When inflation was low and bond yields also low, the opportunity cost of holding cash was not too painful. Many argued that it gave them firepower to jump in and buy bargain-priced equities and bonds whenever the market corrected. But how many had the courage to do that in March 2019?
The sea change in inflation means sitting on the sidelines is now costly. What’s the alternative?
Managing a target return bond fund that aims to deliver 2.5% above the Bank of England base rate over rolling three-year periods, I’m tasked with offering a way to counter or at least soften the blow of inflation while still controlling risk.
This is not an advert; there are other products out there. Do look. The purpose of this piece is to shine a light on the options available for a manager with a cautious mandate, and to reassure investors that there are alternatives to cash that are worth considering in the current climate.
The right tool for each circumstance
I am lucky in having access to a variety of tools, including the ability to short bonds. There are three things I think about each day.
Duration: Persistent, high inflation is bad for the bond market. That’s because a bond generally promises to pay out a set percentage each year for its duration. If the duration is, say, 10 years and suddenly interest rates are increased to counter inflation that promise can look less attractive.
People will look elsewhere for higher returns and the value of your bond will fall to compensate. This is duration risk. Active managers can easily reduce duration risk just in the assets they choose to buy.
Shorting assets is another option. It actually enables us to have negative duration in the portfolio. You have to use this power with care. When you short fixed income assets you are paying out income rather than receiving it.
Experience shows that the odds are greater of being on the winning side if you are long. So you have to be very confident of your view and that it will bear fruit quickly. Still, shorting is a useful tool.
Quality: I have the ability to allocate assets between government bonds, investment grade credit and high yield bonds (the risks rise as you move down the credit quality scale, but so do the potential returns).
Usually, inflation is associated with high growth (I don’t believe we are facing a stagflation environment where growth stalls but inflation rises). In a high-growth environment, you are usually better off tilted towards high yield (currently kicking out around 4% a year on average).
We have a strong economic backdrop for companies at the moment. In aggregate consumers have saved during the Covid crisis and they are itching to spend, which means credit risk is subdued.
Index-linking: The classic way to protect your portfolio from inflation is with index-linked government bonds. They promise to rise in line with inflation. Job done. But that assurance can be expensive.
At the moment we are long Canadian and New Zealand index-linked bonds, but short UK index-linked bonds. Demand for the latter has been so high that they are now priced to assume that the retail price index will be in excess of 4% for each of the next 10 years. It’s only averaged 2.8% since the Bank of England gained independence in 1997.
The likelihood of making money from UK index-linked bonds at current prices is remote. But we think we can by shorting them.
The evidence
Can using a blend of these fixed income tools actually work? The best way to answer that is to look at the drawdown in March 2019 of our own strategy. Past performance is no guide to the future, but the Artemis target return vehicle (net of charges) lost only 3.6%, quickly recovered afterwards and has delivered 10% since its launch at the beginning of December 2019.
In short, cautious bond fund strategies may be a very slow way to double the value of your investment but they can help prevent your cash halving in value and can play a useful part in most portfolios.
Stephen Snowden is co-manager of the Artemis Target Return Bond fund. The views expressed above are his own and should not be taken as investment advice.