Securing portfolios against inflation

Amid volatility in the markets, last year saw phenomenal demand for the relative safe haven of bonds with net retail sales of bond funds reaching a high of £443m, according to figures from the IMA.

Gilts have generated especially high returns for investors due to the increased aversion to risk that has characterised markets since the summer of 2011.

In particular, investors have sought the protection of inflation-linked gilts in a horrible year for the Bank of England, where inflation has hovered at roughly the 5 per cent mark due to higher commodity prices and tax increases.

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Data compiled by Morningstar for Investment Adviser reveals that inflation-linked, or index-linked, bond funds returned an average of 18.51 per cent from January 3 2011 to January 3 2012, compared with a loss of 1.21 per cent for the FTSE All Share equity index.

The top-performing funds of 2011 were mainly housed in the IMA’s UK Index-Linked Gilt sector. The top three performers were Baillie Gifford Active Index-Linked Gilt and Henderson Index-Linked Bond, which gained 23.98 and 22.29 respectively to January 3, followed by the M&G Index-Linked Bond fund, with a return of 22.22 per cent.

However, Mike Riddell, manager of the M&G fund, cautions against attributing all of the demand to last year’s high inflation. The Henderson Index-Linked Bond fund, for instance, profited by positioning for expectations of UK inflation over 30 years to rise against anticipated five-year inflation.

“Some people may jump to the conclusion that this [growth in demand] has been because investors have become increasingly worried about inflation, but this isn’t actually the case. In fact, the market’s inflation expectations have actually fallen over the last 12 months,” he says.

Stephen Jones, manager of the Kames Inflation-Linked fund, says: “There is some respite for the authorities in that in contrast to the recent past we haven’t had an upside surprise [in inflation]. Absolute price levels for goods and services though remain at much higher levels than a year ago.

“The consumer prices index has come in as most people in the market expected at 4.8 per cent year on year. However, the retail prices index at 5.2 per cent remains at painful levels. Inflation will fall, but there is still a lot to do before we get to more acceptable price rise levels, with much scope for disappointment on the way.”

According to George Henderson, an index-linked bond fund manager at Royal London, the relative low price of index-linked products has also contributed to their demand. The manager claims they are the cheapest available in the capital market and give fixed income investors a great opportunity to switch into them at low levels.

Mr Henderson also observes index-linked funds can generate extra returns by managing their duration, or their exposure to the risk of interest rates risking. For instance, he kept his duration short in overseas index-linked gilts as long-dated UK inflation linked bonds’ real yield reached negative levels.

Mr Riddell says the biggest driver of performance on his fund last year was maintaining a long duration position, or exposure to the risk of interest rates rising.