Remember that for an investor who is either approaching, or is in the at retirement phase of their lives, there is the need to balance income requirements, stability of capital value and security along with inflation protection.
To beat inflation, we recommend dividing capital into three portions based on the time horizon for use of the capital. So, using the horizon analogy, an astute bond investor could apply the following formula:
1. Horizon one: 0-5 yrs. Short-dated corporate bonds and high yield bonds (2.5 per cent net)
2. Horizon two: 5-10 yrs. Corporate hybrid capital, and asset-backed bonds (3.5 per cent net)
3. Horizon three: 10 years+ Corporate hybrid capital and subordinated financial debt (5 per cent net)
Take Horizon three as an example. This capital is not needed for 10 years and so can withstand some volatility as long as the bonds ultimately pay back and deliver the promised return. Here, an investor can buy five to seven-year hybrid capital and subordinated debt from the UK’s largest companies such as Aviva, Lloyds Bank and National Grid, where yields can be as high as 6 per cent.
Taking this precedent, 5 per cent net of fees beats current and medium-term inflation. In the event that there is a further increase in inflation and interest rates do go up then re-investment rates will be at even higher future yields.
Remember three key points to beat inflation using bonds:
1. The greater the duration (horizon) mismatch, the more risk will be taken on higher future rates.
2. Most investors still don’t get it – the biggest risk for bond investors is that future yields are lower, not higher.
3. With modest but sustained inflation and somewhat higher interest rates, the largest banks and insurance companies are good place to invest in lower ranked bonds. Don’t fight yesterday’s battles.
Peter Doherty is a fund manager of Tideway Investment Partners
A widespread and largely unexplained feature of investor behaviour during this current bond bull market has been that portfolios with long-dated liabilities have been managed “short duration”.
Boring and complete “asset liability matching” was the low cost option to avoid the punishingly high cost of re-investing.
The best way to beat inflation using bonds is do something similar to those investors who lost out in the past 35 years.