In this week's inflation print, the UK hit a highpoint. According to the Office for National Statistics, the UK's CPI rate hit 3% - a level not seen in more than 5 years. And it's not just the UK - globally inflation has been creeping up.
Inflation is a threat to savers, eroding the spending power of a portfolio. This presents a challenge - how to protect a long run portfolios? There are investment funds which could offer a solution, but this depends on the scenario. Here are three options to protect and perhaps profit from rising prices.
Chart of inflation rates, year on year growth. Historic data (solid line) source: Bloomberg, Office for National Statistics. Past data is no indication of future results. 6 month forecast data (dashed line) source: Société Générale research. The figures relating to future performance are a forecast and are not a reliable indicator of future results.
Scenario 1: Inflation rises, but rates stay low
This scenario is similar to what we're seeing presently in the UK. In late 2015, the CPI rate was negative - it has now risen to 3%.
The Bank of England's rate setting Monetary Policy Committee has one aim - to control inflation. So this latest release puts more pressure on the members to hike rates in response. But this has not so far been the case which means cash savings rates are likely to be below inflation for the meantime.
In these scenarios, a portfolio of inflation linked bonds could be the easiest way for investors to protect themselves. Their interest coupons and their principal values are adjusted with the rate of inflation, creating a direct link. Remember gilt prices move down as well as up; if we hit a period of deflation the interest and principle would fall.
In the UK, index linked gilts are currently benchmarked to the higher RPI rate - currently 3.9% - which is still seen as the benchmark by many pension funds and households. The Lyxor FTSE Actuaries UK Gilts Inflation-Linked (DR) UCITS ETF (GILI) is a physical fund giving access to the whole market of index linked gilts, with ongoing charge just 0.07%.
Scenario 2: Inflation rises and rates are hiked in response
Though UK rates haven't yet been hiked, the question may be "how long"? There are signs of unrest in many banks. Two of the MPC members have been voting for a rate rise since June.
Interest rates are a challenge for inflation linked bonds. A cocktail of long maturity dates with low yields means the indices typically have high duration. When interest rates do escalate, linker prices are vulnerable.
In this scenario, it could be worth looking at inflation expectations. These are constructed to give exposure to the inflation premium, but are hedged against interest rate changes. Inflation expectations overlays have been used (via derivatives) in many institutional portfolios for years, but only in the last year has the strategy been available through UCITS ETFs. Lyxor offers three inflation expectations ETFs - with charges of 0.25%. The most recent launch, Lyxor UK£ 10Y Inflation Expectations UCITS ETF is the first and only fund available on the UK's expected inflation rate.
Scenario 3: Rate hikes lead the inflation rate
The USA is in a different scenario to the UK. Though inflation has been creeping up, American price rises have not hit the two percent goal. Nevertheless interest rates are already rising - the Federal Reserve has forged ahead with several rate hikes already this year.
This scenario could be tough for both conventional and index linked bonds. But floating rate notes could be a solution. These notes fix their coupons to interest rates, thereby raising payments when central banks act. The result is a much more stable return in a rising rate environment. These are not without risk - prices can go down as well as up. These also bear credit risk - issued by corporations not governments, you can lose money if the issuer defaults.
Lyxor recently launched the Lyxor $ Floating Rate Note UCITS ETF (BUOY LN). This is a way to get diversified access to USD floating rate notes - covering 120 notes with charge 0.15%. This is a UCITS fund, eligible for ISAs and SIPPs and has UK reporting status.
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All charge and fund data correct as at 17.10.17. Inflation source: Office for National Statistics
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