‘Linkers’ help combat inflation’s erosive effects

On September 13 the Consumer Prices Advisory Committee is set to discuss issues around UK inflation and, in particular, the recalculation of retail prices index (RPI) inflation.

The change in formula could shave up to 0.9 percentage points off the annual RPI inflation rate. One of the topics under discussion is whether the change in the index is viewed as ‘fundamental’ and is likely to have any ‘material’ impact on holders of index-linked gilts. The meeting will also elicit further details on the inclusion of housing costs in the consumer price index (CPI) in the case of owners who occupy their own properties. Over time, CPI may well become the official UK inflation rate. Indeed, in anticipation of any reforms, many new issues are already based on CPI.

However this debate pans out, there is no doubt that index-linked bonds or ‘linkers’ can represent a tax-efficient, and relatively low-risk, way of maintaining the real value of funds, particularly in an environment of quite high inflation. We have recently reduced our exposure, but current, more aggressive falls in the rate of inflation have led to some weakness in index-linked prices. Breakeven rates – the difference between yields on index-linked gilts and gilts with a fixed annual coupon maturing at similar times – have fallen further. We also believe the inexorable falls in gilt yields are coming to an end. This presents a buying opportunity in coming months.

Given the debt pile of most developed economies, central banks cannot allow the rate of inflation to fall too far, or worse, turn negative, since deflation will cause the debt burden to grow even further. Governments, including our own, have every incentive to sustain a degree of inflation, and so further stimulus is likely in order to keep inflation positive. This supports the case for buying linkers on dips. Even if there is too much stimulus, and inflation becomes more entrenched over time, this presents another reason to hold index-linked bonds.

But for those investors looking for a broader range of exposure – or those nervous about potential changes to the way the official inflation rate is calculated – infrastructure funds can also offer an inflation-linked hedge. The classic approach to growing the economy is to take some pain by shifting the debt burden, followed by a focus on growth – hence, the stasis in growth that we are experiencing today.

However, the government’s response lies in the low cost of funding – its current ability to borrow below the cost of inflation. Consumers cannot spend their way out of recession, especially while the banks sit tactically on duff loans. Infrastructure spending therefore looks rational.