Inflation may not be so much an issue right now, with deflation concerns higher up the agenda, but the consensus seems to be that the UK will feel inflationary forces sooner rather than later.
With that in mind, M&G is to launch an inflation-linked corporate bond fund, even though the firm is not entirely behind the idea that inflation is a concern – just yet.
Jim Leaviss, joint manager of the new fund, may not see inflation as a worry today but he feels it is a concern for investors.
Liontrust’s head of fixed interest Simon Thorp says that with fixedincome markets at their current prices, investors see more risk from inflation than deflation. Flows into index-linked gilt strategies this year bear out that sentiment.
The amounts are not staggering but there has been a noticeable increase in sales in the IMA index-linked gilt sector. Every month this year has seen higher inflows compared with the same months last year, according to sales data from the Investment management Association. In April, May, June and July 2009, the sector saw inflows of £31m, £35m, £33 and £41m while this year the figures for those months were £49m, £61m, £53m and £49m in gross retail sales.
In August Ian Spreadbury, manager of Fidelity’s strategic bond fund, added some inflation-proof assets to his portfolio even though, like Leaviss, he does not see inflation as an immediate concern.
He says: “I took the opportunity to add some UK inflation-linked bonds for a couple of reasons. First, valuations. Real yields on 15-year bonds briefly touched 1 per cent, having spent most of the year under 1 per cent. Break-even inflation rates declined from 3.6 per cent to 3 per cent, which is quite a sharp drop. Second, inflation-linked bonds are a good portfolio diversifier. I am not too concerned about inflation taking off in the short run but I do think it is a longer-term risk, particularly with the possibility of more quantitative easing.”
Spreadbury’s colleague Andy Weir, manager of Fidelity’s global inflation-linked bond Sicav, considers that inflation is likely to stay constrained over the next 12 months but he also feels government action brings uncertainty to the current outlook.
Weir said: “Understanding when and how monetary stimulus will translate into higher inflation is an imprecise science. Over the past three years, enormous liquidity has been pumped into developed economies and the US Federal Reserve’s $2 trillion-plus balance sheet provides the clearest evidence of this. The volume is unprecedented and while low velocity of money and inflation expectations has until now kept inflation in check, there is a risk that inflation expectations rise at some stage.
“It is a commonly held view that there is a two-year lag between monetary policy actions and any effect being seen on inflation.
“On this basis, inflation may become a greater concern in 2011. The problem, however, is that history also suggests that inflation expectations, once altered, are difficult to change.”
Thorp noted that the problem with inflation if and when it does return is that it will happen when the market has finally convinced itself inflation is dead. The data will only confirm its existence once it is already entrenched in the economy, he said.
Weir suggested that in order to hedge against the inflation unknowns, investors should look towards a blend of solutions. Within fixed-income markets, he said “linkers” are the natural solution and investors should remember there are more available in this universe than just index-linked gilts. Outside of bonds, Weir pointed to real estate, gold as well as equities.
’It is a commonly held view that there is a two-year lag between monetary policy actions and any effect being seen on inflation. On this basis, inflation may become a greater concern in 2011’
He added: “Equities have returned higher real yields over the very long term but their use as an inflation hedge is imprecise over shorter time periods, requiring excellent stock-picking skills. They also exhibit high volatility. Stocks in the natural resources, tobacco, food and pharmaceutical sectors are popular among investors for this purpose.”
There are options available to UK retail investors but dedicated inflation funds are fairly rare. Fidelity may have added its global inflation-linked fund in May 2008 but more than half of the 16 portfolios in the IMA’s index-linked gilt sector have 10-year track records. All, bar three, been around for more than five years, according to data from Financial Express, and, of those that are around, they are not exactly big. Take away the two biggest funds in the sector and the index-link gilt peer group has around £2bn in combined assets. Factsheet data on Financial Express shows the two biggest portfolios, Legal & General all stocks index-linked gilt and Standard Life TM UK inflationlinked bond, have £888.1m and £901m respectively.
Exposed to corporate rather than government debt, M&G’s latest fund gives investors another choice for inflation-proofing. Although it may be a new concept in fund form, investing in inflation-linked corporates is not new. Leaviss says pension funds are the biggest buyers of the individual issues, the majority of which come from utilities, so it is an area M&G has been involved with for decades. The company’s indexlinked gilt fund even holds a small portfolio in inflation-linked corporates.
Ideally, M&G’s new launch would be suited for a high-inflation market but Leaviss says the firm did not want to wait for inflation to be upon the market before launching the portfolio. “It is like building the fire engine ahead of the fire,” he says.
The company believes the fund is the first of its kind in the world but M&G itself could perhaps be considered unique for launching a portfolio before a trend exists, unlike bandwagon fund offerings that are launched at the height of a market.
However, if fixed-interest managers are correct, then M&G’s latest inflation-proofing fund may not be the last we see for a while.