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Technically Speaking: Where is the index finger pointing?

In my last few articles, I have tried to identify likely future investment returns from some of the core asset classes including cash, fixed-interest gilts and corporate bonds.

This week, I will continue by looking at index-linked investments and property before moving on to equities.

Fundamentally, the only significant market in index-linked securities is Government bonds. The return on these bonds is linked to price inflation, with the underlying interest payment – typically around 2 or 3 per cent at the date of issue of the bond – and the capital value rising each year in line with price inflation.

On the face of it, whereas fixed-interest gilt prices are determined primarily by the outlook for future interest rates, index-linked prices are determined by the outlook for future levels of inflation. However, life is not quite so simple.

At the time of writing, the redemption yield on a 20-year fixed-interest Government bond is 4.7 per cent while the redemption yield on an equivalent-dated index-linked bond is 2 per cent. Market prices in both these investments is determined by the effect of supply and demand between buyers and sellers, the vast majority of whom are institutional investors trading in vast sums of money.

One can assume that, at any time, the prices of fixed-interest and index-linked Government bonds are in equilibrium, meaning the market thinks that they are both likely to represent the same value for money.

For this to be the case, the following information is simple to deduce:

Fixed-interest gilt redemption yield 4.7%

Index-linked gilt redemption yield 2%

Implied expectation of future inflation 2.7%

Thus, the market believes that future inflation over the 20-year period of these particular gilts is likely to be 2.7 per cent. I would suggest that this updated projection should be of interest to IFAs for a number of reasons, not least in projecting the real (net present) value of a projected fund from an investment or pension contract in today&#39s terms.

But looking at index-linked gilts not just as an indicator of core financial projections but as an investment asset class in their own right, what could change the price of this form of investment? The answer to this question is key to the possible or likely attraction of this asset class to investors.

First, if the market starts to believe that future inflation rates will increase, then the attractions of inflation-proofed investments will obviously rise, increasing demand and raising prices.

Amending my earlier example, if the market believes that future inflation will be 3.4 per cent rather than 2.7 per cent and if fixed-interest gilt yields remain the same, the comparative situation is as follows:

Current Higher

expectation inflation

expectation

Fixed-interest gilt redemption yield 4.7% 4.7%

Index-linked gilt redemption yield 2% 1.3%

Implied expectation of future inflation 2.7% 3.4%

For the redemption yield of an index-linked gilt to fall, the price must have risen – in this example, by some considerable amount although this increase would obviously not have happened over a very short period of time.

Stating the fairly obvious, therefore, investors who believe that inflation will rise in the coming years could be well advised to include index-linked gilts in their portfolio.

However, the attraction of these investments applies not only to clients who believe inflation will rise but also to those who have no thoughts as to the future direction of inflation but fear it will rise.

Index-linked gilts can be a valuable part of a portfolio for those of us whose outgoings are mostly variable and likely to increase, at least in line with inflation. If inflation remains relatively low, then the return on a holding of index-linked gilts will remain relatively low but our outgoings are not likely to be increasing rapidly. If inflation returns to a very high level, then although our outgoings will be increasing, so will the income and, more important, the capital returns from index-linked gilts.

However, it is not only expectations of future inflation rates which affect index-linked gilt prices, they can also be affected by interest rates. Take our example above. What if the market&#39s expectation of future inflation rates remains the same but interest rates increase, let us say, from the current long-dated gilt redemption rate of 4.7 per cent to 5.3 per cent. The following revised comparison would occur:

Current Higher

interest rate interest rate

Fixed-interest gilt redemption yield 4.7% 5.3%

Index-linked gilt redemption yield 2% 2.6%

Implied expectation of future inflation 2.7% 2.7%

In summary, market prices of index-linked gilts will be determined not only by expectations of future inflation rates but also by interest rates. Investors should ensure they consider both these aspects when considering investing in or remaining invested in this asset class.

I will now move on to an asset class which I continue to find extremely attractive as a potential part of many or most clients&#39 investment portfolios – commercial property.

An increasing number of IFAs have been investing an increasing proportion of client money in property funds over the last few years and with very good reason – even half-decent property funds have produced very good annual returns for the last three or four years. But are they likely to continue to do so over the next few months and years?

As I have mentioned in previous articles, the widely-accepted key index of commercial property returns is provided by Investment Property Databank, details from which can be found on its excellent website at ipdindex.com.

Towards the end of 2002 and by the start of last year, this index was reporting that monthly returns from commercial property had fallen to around 0.6 per cent, indicating annualised returns of somewhere around 7.5 per cent. This figure was much lower than it had been for a few years and had been falling throughout 2002.

On the one hand, supporters of commercial property as an investment asset class might have been concerned about the steady decline in rates although, it must be noted, 7.5 per cent still represented a very healthy return. However, throughout last year, commercial property returns steadily improved to the current situation – an important update for all investment advisers.

For the last few months, the IPD index has reported that total returns (that is, taking into account rental income and fluctuations in capital value) have been hovering around 1 per cent a month, indicating annualised returns in excess of 12 per cent.

These monthly returns do not tend to fluctuate greatly over the short term, as indicated by the latest figures up to the end of November 2003 (there is always a short time lag in the index due to the logistic of collecting and summarising returns):

November 2003 0.9%

Previous three months 3.2%

Previous six months 5.7%

Previous 12 months 10.7%

Clearly, property returns have not only held up well over the last months but have steadily improved. I would, therefore, strongly suggest that all IFAs who advise or consider advising investment in property funds should regularly update themselves, courtesy of IPD.

I will write a little bit more about property funds in my next article before we move on to equities, the last of the major asset classes yet to be discussed in this short series on future projections.

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