How to beat inflation: cash and inflation-linked products

Published by Heather Connon on 09 October 2012.
Last updated on 09 October 2012

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%.


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

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