How to beat inflation: cash and inflation-linked products
Between 1970 and 1990, inflation reduced the value of every £1 to just 14p, according to calculations by Paul Killik, founder of stockbrokers Killik & Co.
For five years during that period, prices were rising by more than 15% a year and the average over the two decades was 10%. Between 2002 and 2012, by contrast, the average has been just a little over 3% and, apart from the odd blip, inflation this year has been falling again.
But even a little inflation is a dangerous thing: Tim Cockerill, head of collectives research at Rowan Dartington, points out that since 2005, the Consumer Prices Index (CPI) has increased by 22.5%.
Investors will have had to earn at least that return on their investments over the past five years to avoid eroding their capital but, with interest rates having been 0.5% since March 2009, getting that return from cash holdings has been nigh impossible, while the dismal stockmarket performance means that just 65 of the nearly 400 UK equity funds that have been around that long have delivered a return ahead of that inflation rate.
UK fixed interest funds have fared better, with 105 out of 130 beating inflation over the period.
Bad news for pensioners
Inflation is particularly bad news for pensioners and others whose income is fixed. Laith Khalaf, pension investment manager at Hargreaves Lansdown, says: "A pension will be drawn for 20 to 30 years, maybe more. Inflation is therefore always going to be a major threat to pensioners. Even at a modest level of 2.5%, inflation will halve the value of a fixed income over 28 years. At 5% it will halve it over 14 years."
Nor is there any guarantee that inflation will continue to fall. While the Monetary Policy Committee expects inflation to fall further this year, others are less convinced that the long-term trend will be downwards.
Simon Callow, manager of the CF Midas Balanced Growth Fund, is convinced that inflation will be a long-term issue for investors. "I am mystified that everyone seems so relaxed about inflation. You have to distinguish between what is happening in western economies [where growth and consumer demand have slowed sharply] and what is going on elsewhere.
Wages have increased sharply in China, so the products they manufacture are becoming increasingly expensive and that will be exported to the western world."
In addition, he says, agricultural commodities have been rising sharply - particularly corn and soybeans following the prolonged drought in the US. While commentators tend to write these offas one-off, weather related events, Callow points out that these "temporary" weather effects are happening every year, while the rising population is also increasing demand for foodstuff.
Quantitative easing (QE), under which the Bank of England has poured £375 billion into buying bonds in an effort to stimulate bank lending and the wider economy, and similar operations in the US and Europe could also push inflation higher in the medium term - indeed, the bank has admitted that inflation is already higher than it would otherwise have been because of QE.
"The huge increase in the money supply will increase inflation at some stage," says Peter Day, a partner with Killik & Co.
So how can investors protect themselves against inflation?
Holding cash may sound safe; but with base rates at 0.5%, it is one of the worst ways to protect against inflation. Moneyfacts points out that, with CPI inflation at 2.6%, a basic-rate taxpayer needs to find an account paying at least 3.25% and a higher-rate taxpayer 4.3%.
It estimates that about 70 accounts meet that for basic-rate taxpayers (most of which are fixed-rate bonds). There are 29 variable ISAs and 105 fixed-rate Isas that pay more than 2.6%.
INFLATION-LINKED SAVINGS PRODUCTS
A product that offers a return linked to inflation seems like the obvious way to protect the real value of cash but, as with all investments, there are caveats.
National Savings & Investments (NS&I) index-linked bonds, which guaranteed a return of a particular amount above inflation and were tax-free, were perfect but, unfortunately, there are currently no issues available and it says it is unlikely any will be offered in the current fiscal year.
The 15th issue of Santander's inflation-linked bond also closed in mid-September and, at the time of writing, there were no others available.
Government issued index-linked bonds have been available for years but a number of companies, including National Grid, Tesco and Severn Trent, have also started issuing debt with returns that are linked to inflation and, since the launch of the secondary market for bonds - the Order Book for Retail Bonds - last year, dealing in them has become far easier for private investors.
On the face of it, these are the perfect inflation hedge as their coupon, or interest rate, generally offers a fixed premium over the Retail Prices Index (RPI) or CPI and, as with gilts, you get your money back on maturity. As with all bonds, however, the likelihood of getting your money back depends on the creditworthiness of the issuer and, while the UK government looks pretty safe - unlike some European ones - companies are riskier.
The return you get will also vary if you buy on the secondary market because the price at which they are traded fluctuates between launch and maturity.
If you buy after the launch, you could have to pay more than the bond will be worth when it is redeemed, risking a capital loss. And the income return on your investment will also depend on what you actually pay in the secondary market: if you pay more than the bond's face value, the yield will be below the stated coupon and vice versa.
Cockerill calculates that the break-even inflation rate for long-dated index-linked gilts is currently 2.4%. "If inflation over the life of the gilt is higher than 2.4% investors are better off in it than they would be in the equivalent conventional gilt. It seems to me inflation could easily average more than 2.4% over the coming 10 years especially with all the QE there has been."
Killik's Day points out that the calculation of when to buy an index-linked corporate bond is complicated and will change depending on interest and inflation rate expectations. At current prices, it would have been marginally better to have bought National Grid's inflation-linked bond after issue, but that will not always be the case.
Long-term investors who want a simple hedge against inflation may find it better to buy an index-linked gilt or corporate bond on issue and hold it until maturity.
This article was written for our sister magazine Money Observer
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.