In March, UK consumer prices index inflation rose to 3.5 per cent, and Paul Tucker, deputy governor of the Bank of England has warned that it is likely to stay that way for the rest of the year.
This is in spite of the Bank’s previous forecast that the inflation rate would “probably fall to the official 2 per cent target by the end of 2012”.
Notwithstanding projections of a general downward trend over the medium term, investors and advisers should therefore be taking steps to mitigate the impact of this stubbornly high inflation on their portfolio performance.
Russ Koesterich, managing director and chief investment strategist at iShares, argues that fixed income investors face a stark choice between low nominal rates and often negative real rates, or increasing risk to generate incremental yield.
“We would advocate reducing duration risk, for which we believe investors are not being adequately compensated, and modestly increasing exposure to spread products.
“We would advocate looking to US corporate debt, specifically investment grade, high-grade municipals and emerging markets.”
Nick Gartside, CIO of Fixed income at J.P. Morgan Asset Management agrees, adding: “Government yields, close to generational lows, still look unattractive and we expect Treasury yields to bubble higher over the next few months as the eurozone risk premium is unwound and as the market adjusts to the reality of better economic data prints.
“Emerging market debt continues to be one of our top picks as do other spread sectors such as high yield, where both fundamentals and valuations look good.”
However, with real yields substantially lower over the past few years and the UK experiencing persistently above-target inflation, pricing for inflation-linked gilts has become very firm.
At the start of the year, veteran bond investor Jim Leaviss raised exposure to index-linked bonds in his M&G Global Macro Bond fund to a record high level, based on his view that break-even rates – the difference in yield between a nominal and an index-linked bond – are highly attractive.
He says: “Inflation protection is cheap and should be considered by investors who are concerned about future price rises.”
According to Investec Wealth and Investment, the difference between the yields on a 10-year conventional gilt and a 10-year inflation-linked gilt is approximately 2.8 per cent, based on the implied rate of UK inflation over the next 10 years derived from the gilt market.
Given that inflation-linked gilts provide protection from the retail price index rather than CPI and, historically, the difference between the two measures has been around 0.6-0.8 per cent, this suggests that investors are locking into a break-even CPI inflation rate of roughly 2 per cent.
Darren Ruane, senior bond strategist at Investec Wealth and Investment, explains: “Investors generally want to achieve returns greater than inflation over the life of an investment and real returns from inflation-linked gilts are currently negative.
“In addition, at some point, real government bond yields could adjust to rates of maybe 2 per cent to 3 per cent once the economic cycle has normalised.