How to inflation-proof a portfolio

According to Adrian Hull, senior fixed income product specialist at Kames Capital, "It is likely that headline UK RPI will push higher than the whole of the nominal gilt yield curve in 2017."

This will be caused by multiple factors, including political uncertainty around Trumponomics when Donald Trump officially accedes to the White House, and a potential inflationary effect caused by the triggering of Article 50 in the UK.

Chris Saint, currency analyst for Hargreaves Lansdown, concurs: "The UK economy has held up relatively well in the short time since the referendum.

"However, without clarity on the blueprint for exiting the EU, the longer-term consequences are still open to debate.

"Exchange rates are determined by the interaction of a diverse range of political and economic factors, including interest rates, inflation and growth, all of which are up for grabs in 2017, which is likely to make for lively currency markets in the coming year."

A poll carried out by Hargreaves among fund managers in December revealed:

• The median forecast is for the UK to achieve growth of 1.1 to 1.5 per cent in 2017.
• 75 per cent of respondents anticipate inflation will be higher than the Bank of England’s 2 per cent target by the end of next year.
• The most common prediction was that inflation would be between 2.6 per cent to 3 per cent.

This means investors are likely to see similar inflation valuations to those experienced in 2011. 

Short duration is much lower down the risk scale and far less sensitive to both interest rate rises and inflation, but will not offer much of a yield if that is what you are after. Darius McDermott

This is why, according to Mr Hull, index-linked securities are a good way to protect a portfolio.

"Index-linked securities are likely to be better performers if inflation is higher than the current consensus of RPI, at around 2.75 per cent in 2017," he says.

However, George Efstathopoulos, multi-asset portfolio manager for Fidelity International, is not so keen on linkers. 

He comments: "Investors should consider having some core inflation-proof exposure. 

"While inflation-linked bonds are the obvious candidate, they do not pay a high level of income. Moreover, they can still post negative returns in an inflation-rising environment, should real yields also rise."

Instead, Mr Efstathopoulos advocates using financial debt as a reflation hedge. "This pays a higher income and should benefit in a yield-steepening environment as bank net interest margins improve.

"Also, floating rate instruments, such as leveraged loans - which offer better downside protection than high-yield bonds, with comparable levels of income - could rise, should Libor also rise."

The need to protect against inflation can be seen in a snapshot from EPFR's global-tracked bond fund analysis.

According to the data, inflation-protected bond funds saw significant inflows from investors across Europe and the UK.

More than £9bn worth of investors' money flowed into the sector by the fourth quarter of 2016, compared with just £5.1bn in 2015.

Table: EPFR Bond Fund Flows 2015-2016

Short duration

Index-linking is not the only way to proof a portfolio against the ravages of inflation; a short-duration strategy is also popular with some fund managers.

In an article by Ashish Shah and Scott DiMaggio of AB (formerly Alliance Bernstein), they warn: "Investors who have moved to passively managed global aggregate bonds funds - which had about 7.5 years of duration and a 1.8 per cent yield to maturity as of 31 August 2016 - have a lot more exposure to duration than they realise.

"The days of making money in a falling-rate environment are over. When interest rates rise, investors who have long-duration positions are usually punished."

Chris Iggo, chief investment officer of fixed income for Axa Investment Managers, comments: "In our view, a fixed income portfolio still has to be focused on limiting downside as we go through the adjustment in (mostly interest rate) risk premiums in bond markets.

"This suggests keeping duration exposure quite short, and focusing on carry opportunities in the markets, with high yield and emerging markets providing the best of these in the short-term."

Rotation

Mr Iggo added that a potential "playbook" for bonds over the next year or so is that rates keep rising as the US economic upturn spreads to other parts of the world, which will translate into tougher financial conditions.

If so, there could be a situation where credit spreads widen. "This can happen quickly," Mr Iggo explains. "The playbook would therefore be to keep duration short as rates rise, gradually reduce credit exposure as spreads reach tighter levels and look to add back duration as evidence starts to emerge of the cycle peaking.

"Finally, buy back credit risk again when spreads have widened."

Although this is far too complicated for the average retail investor, fund managers expect a trigger for this rotation back into government bonds could be when there are US Treasury yields above 3 per cent.

Outlook

However, not everyone is convinced the high predicted levels of inflation will be persistent and permanent.

Darius McDermott, managing director of Chelsea Financial Services, comments: "Investors could consider inflation-proofing their portfolios a little but I'm not sure there is any substantial evidence that inflation will be a permanent feature at the moment.

"The start of 2017 has already shown how the difference in the oil price can cause a spike - but only a temporary one - as will sterling's fall post-Brexit later in the year. But I can't see any signs of a prolonged or high inflationary period right now.

"If you disagree, either end of the bond spectrum could work, depending on investors' personal risk preferences. Short duration is much lower down the risk scale and far less sensitive to both interest rate rises and inflation, but will not offer much of a yield if that is what you are after.

"Higher yielding bond funds will be more sensitive, but that higher yield should act as a cushion and help total returns stay in the positive."

simoney.kyriakou@ft.com