Mark Dampier: Ingenious M&G has an answer to inflation risks

The Analyst

The arguments over whether we face inflation or deflation continue. The recent decision by the Bank of England to reintroduce Quantitative Easing (QE) suggests the Monetary Policy Committee is not too worried about inflation in the near future, although it is fair to point out its own forecasting has been especially poor over the last few years.

Retail investors certainly have been worried about the threats of inflation though. The popularity of National Savings Index-Linked Savings Certificates is testimony. Not only were these straightforward to understand, but they were tax free and capital guaranteed. Little wonder then they quickly sold out.

It is a very different matter when investing in index-linked gilts. You have to tread very careful as you are buying an instrument with considerable market risk. The vast majority of index-linked gilts are of long duration, ie they have long maturity dates, so they carry the risk that interest rates go up – perhaps in response to increasing inflationary expectations. What this means is that if interest rates move up quickly, ironically, long-dated index-linked gilts and bonds are likely to underperform.

In recognition of this the M&G UK Inflation Linked Corporate Bond Fund managed by Jim Leaviss and Ben Lord is effectively a short-dated fund investing in index-linked gilts and corporate bonds. There are relatively few corporate bonds issued on an index-linked basis as companies tend to prefer to fix their debt payments at a level amount. Yet with a little ingenuity M&G have been able to achieve a greater level of diversity. They create "synthetic" index-linked corporate bonds by buying index-linked gilts and selling protection against company default via the CDS (credit default swap) market.

Essentially, what this all means is that by buying the M&G fund you are investing in a collection of short-duration inflation-linked assets, which should perform relatively well in a rising interest rate environment as well as being less sensitive to interest rate movements than long-dated index-linked gilts. Additionally, there is a higher return than a pure short-dated gilt fund because of the credit risk involved. So for investors wishing to buy bonds but worried about future inflation this fund looks like a good solution.

The fund had an extremely good start but has recently fallen back amidst a weak corporate bond market worried about the solvency of European governments and financial institutions. However, Mr Lord feels the volatility is creating opportunities – especially in index linkers. A good way to assess the attractiveness of index-linked gilts is the "break-even" inflation rate – the rate of inflation where returns from an index-linked gilt held to redemption equal those of an equivalent conventional gilt. If you think the average inflation rate will be higher than the break-even rate between now and maturity, then index-linked gilts look better value. He notes the five-year breakeven inflation rate is currently about 2.3 per cent. If RPI is around 5 per cent, or possibly 6 per cent, over the next 12 months it implies the market believes it will be very low for the following four years. So if inflation turns out to be higher then linkers look good value.

It should be noted that the fund is run on the basis that high inflation will persist. There is actually some irony here as the M&G team themselves feel the rate will start to moderate quite quickly in 2012. However, I believe over the longer term politicians are likely to try to inflate away the colossal amount of debt accumulated. QE and ultra-low interest rates risk serious currency debasement and import inflation via energy and commodity prices, but they will continue to be the easy option politically. It now looks to me that the market could be underestimating the threat of inflation in the UK. Combine this with the fact that the corporate bond market has sold off lately and you have a very interesting opportunity, and with the M&G team you have some exceptional talent in this area.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.h-l.co.uk/independent