February 4, 2011 5:44 pm

New funds offer inflation link

Private investors seeking to protect their savings from inflation can now make use of two new index-linked bond funds.

Vanguard, the US low-cost fund manager, and Swiss & Global, the asset manager spun off from Julius Baer Bank, have this week launched funds holding inflation-linked government bonds from the UK and select emerging markets. Their announcements come just four months after M&G set up the first UK inflation-linked corporate bond fund, and follow fresh warnings about rising consumer prices.

On Tuesday, manufacturing data from China, India and other Asian countries suggested that inflationary pressures are still growing in the region – and likely to be imported to the west. Chinese inflation rose above 5 per cent in November, and the UK’s consumer price index (CPI) jumped to 3.7 per cent a month later.

Index-linked bonds can provide a hedge against rising inflation as their interest payments – and, in the case of UK gilts, their redemption values – rise in line with an inflation index. In the UK, the retail price index (RPI), which currently gives a higher inflation reading of 4.8 per cent, is used.

Vanguard’s UK Inflation-Linked Gilt Index Fund holds 16 of these index-linked gilts with the aim of tracking the Barclays Capital UK Government Inflation-Linked Float Adjusted Bond Index. As it is an index tracker – employing optimised replication of the index constituents rather than active management – it has an annual charge of 0.15 per cent, plus a temporary levy of 0.4 per cent to offset dealing costs while the fund is still small.

Swiss & Global’s Julius Baer Emerging Markets Inflation Linked Bond Fund, meanwhile, invests in an actively-managed portfolio of index-linked bonds issued by the governments of countries such as Brazil, Chile, Israel, Mexico, Korea, Poland, South Africa and Turkey. It is a Luxembourg domiciled fund, but compliant with the Ucits III regulations, and carries an annual charge of 1.3 per cent.

M&G’s Index-linked UK Corporate Bond Fund, which was launched in September, differs in that it holds inflation-linked bonds issued by UK companies – as well as conventional corporate bonds and derivatives – with the aim of producing returns in excess of the CPI. It has an annual charge of 1 per cent and an initial charge of 3 per cent.

Some analysts believe funds such as these represent the only practical way for private investors to hedge against rising consumer prices. “The purest insurance is index-linked government bonds and the best way of accessing this market is via a global fund,” said Andrew Wells of investment group Fidelity.

UK private investors could buy individual index-linked gilts through a broker that uses the London Stock Exchange’s Retail Bond Platform – but independent adviser Brian Dennehy, of Dennehy Weller & Co, pointed out that higher-yielding global and corporate bonds are almost impossible to buy, because of high minimum deal sizes. “Fund managers can at least add an intelligent overlay,” he said. “My guess is that the better managers will provide something close to inflation protection.”

However, index-linked bond funds still carry risks. Funds that trade in and out of bonds on the open market will be buying at higher prices, and lower yields, than newly-issued bonds – reducing potential returns.

“A perfect hedge against inflation will only exist from issue date till maturity,” warned Willem Sels, UK head of investment strategy at HSBC Private Bank. “The day after issuance, the bond may already price a lot above par or below par.” In the US, yields on index-linked bonds fell so low in October that five-year issues were offering a return of less than inflation. “What’s important is how much are you paying for that protection,” explained Stuart Ratcliff of the Matrix Credit Opportunities Fund. “The market prices inflation expectations into inflation-linked bonds – this is called the ‘breakeven rate’. The UK 10-year breakeven rate is 3.21 per cent today. So, if you believe that inflation will be higher than 3.21 per cent over the next 10 years, you should buy, otherwise you may be wasting your money.”

Anthony Doyle, of M&G’s bond team, admitted that charges have an effect, too. “Don’t forget that there are also trading costs,” he said.

For this reason – and for tax-efficiency – some advisers argue that UK investors would be better off ignoring funds and simply buying index-linked gilts.

“Their capital uplift attracts neither capital gains tax nor income tax,” said Rob Burgeman, a director at Brewin Dolphin, the private client investment manager. “There seems little sense in buying a UK index-linked gilt fund and trading a tax-free return for an annual management charge and a potential capital gain on disposal.”

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