The majority of investors just want to keep their money safe but doing so these days comes at a price. Putting money on deposit earns a tiny interest rate, while the rate on a government bond is still poor by historical standards.
If you want to protect money against future inflation losses, you are faced with a choice of government index-linked bonds offering negative real yields.
When interest rates fall bond prices rise, so new buyers who receive the fixed income available only receive reduced income as a percentage of capital invested. The real yields are now negative as the bonds have gone up in price.
Government index-linked bonds should be a natural asset for pension funds as they give income and protect it, as well as capital, from erosion by price rises. They should also be good for individuals wanting to protect their savings over the longer term against inflation. Now these bonds offer a negative yield it is no longer a guaranteed answer to the problem of how to both protect your capital from inflation and make a return on it. If you buy and hold to repayment by the government you have to accept a negative yield (though you will of course get back a capital value enhanced in cash terms by the inflation protection).
Many pension funds accept advice to have so-called matching assets or bonds in their portfolios. Many portfolio managers like index-linked gilts because they tend to be long-term investments. In an era of low, falling interest rates you make more money by locking into long-dated bonds. In a period of low and often falling inflation, index-linked gilts have delivered great returns. The relative shortage of these bonds compared with strong demand from pension funds and others has also served to deliver good returns. The problem with index-linked gilts going forward, however, is that interest rates will rise again. In such conditions, long-dated index linkers will be prone to falls in price, all else being equal.
If interest rates go up because inflation is accelerating, there will be some offset for holders of index-linked gilts. People may come to value the inflation protection even more. These numbers become significant if there is a major change in the inflation rate. So are index-linked gilts a good idea? They are now a lot more expensive and, in some conditions when interest rates rise, will lose you money. There is no simple guarantee of a real return any more.
Some think a diversified portfolio of shares can achieve steady income and protection of capital against future inflation. Shares, on average, offer a better running income than high-grade advanced country bonds. The income rises as dividends and profits grow. A portfolio reflecting a major advanced economy or one based on the world index of leading companies is plugged into the natural growth that comes from rising population, better technology, productivity improvements and new product developments.
However, the problem with share investment for the prudent is capital values of what you own can swing substantially as market moods and economies alter. You may have a portfolio of quality shares with rising dividends and growing income but if markets are hit by something like the technology bubble burst you can lose a substantial part of your asset value in the short term. Therefore, the hunt is on for decent income with less risk than the average share market. True long-term holders can afford to look through a couple of years of losses but it takes strong nerves to avoid selling out as shares fall and good judgement to see which portfolios emerge successfully.
There are several ways people find additional income. They usually entail taking more risk than putting money on deposit or buying a government bond, though. One is to select shares in large, more stable businesses offering better prospects of steady income. Some think this is the case for utilities, where demand for water, energy and telecoms is relatively more stable than demand for air flights or hotel stays. If you buy those shares they may be more resilient in a market downturn and better able to avoid cutting their dividends. They still have risks, though, including policy change, in what are heavily regulated activities. They also offer less income than they used to as others have already bought into this idea.
The second is to buy bonds from companies rather than governments. You run more risk as individual companies are more likely to get into financial trouble and be unable to pay the interest than advanced country governments, but you do get paid more income as a result.
The UK is currently seeking to invest more in infrastructure, such as railway and road capacity, to cater for a growing population. This needs financing. Maybe someone will come up with a new kind of infrastructure bond. If they could design one that does not have a government guarantee but gave the investor access to the revenue flows from large new infrastructure with relatively stable future demand, that could be closer to what the pension fund and the prudent saver have in mind. An index-linked bond that offers a small real yield rather than a negative real yield would be of interest. In the meantime, in an era of low yields, extra income entails taking more risk.
John Redwood is global investment strategist at Charles Stanley