Benstead on Bonds: what pros who think inflation is here to stay are buying

These three wealth preservation trusts have high weightings to this type of bond amid concerns that inflation has become embedded. Sam Benstead explains how these bonds work, and whether they would be a good fit for your portfolio. 

The big three wealth preservation investment trusts – Ruffer, Capital Gearing and Personal Assets – share the lofty aim of protecting investors’ money on an inflation-adjusted basis, and then growing it as a secondary goal.

They deploy different approaches to achieve this, but all have one thing in common: a love for inflation-linked, also known as index-linked, bonds.

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Ruffer Investment Company has 17% invested, Personal Assets has 35%, while Capital Gearing has 46%. These allocations include inflation-linked bonds issued by the US government, known as TIPS (Treasury Inflation‑Protected Securities) and those issued by the UK government, index-linked gilts. However, the American bonds are more popular among the fund managers.

Inflation-linked bonds promise the bond holder coupons and the final principal adjusted for inflation. US bonds are tied to CPI there, while UK bonds are tied to the Retail Price Index (RPI), which tends to be greater than Consumer Price Index (CPI) as it includes mortgage costs.

If inflation is positive, the total return of the bonds increases. For example, 30% inflation over a five-year maturity period will lead to a bond issued at £100 paying back £130 on maturity, with coupons also adjusted for inflation.

The yield stated on an inflation-linked bond is the “real” yield, and shows the return an investor will get above the rate of inflation in the issue country.

For example, an index-linked gilt maturing in 2035 currently yields 0.65% above the RPI inflation rate in the UK. In the US, a TIP maturing at a similar time, yields 1.5% above America’s CPI rate.

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Inflation-linked bonds will generally rise in price when interest rates fall, just as normal bonds do, but will also perform well when inflation rises, which is a scenario that may hurt normal bonds as the real value of their coupon will be eroded. Rising interest rates will hurt inflation-linked bonds as they do normal bonds, so a scenario of high and rising inflation without higher interest rates is ideal for this asset class.

Rising interest rates last year clobbered the asset class, with investors repricing the longest-dated bonds most severely, leading to inflation-linked bonds being hit hard. In the UK, where 25% of gilts are inflation linked, they tend to be very long dated as they are mainly bought by institutional investors to match their liabilities way out into the future. An index-linked gilt maturing in 2068 dropped from £330 to about £100 last year. It now trades at £77.

But now that these bonds have repriced for higher interest rates, yields have risen, and they are considered an ideal protection against stubborn inflation and a weak economic backdrop. Not only will they rise in value if interest rates fall to stimulate struggling economies, but inflation-adjusted payouts are now substantial.

High levels of inflation meant that Personal Assets Trust could actually pay a special dividend in its latest financial year of 2.1p per share.

The trust’s manager, Sebastian Lyon, argues that inflation has become embedded, particularly due to the increased bargaining power of labour in the aftermath of the pandemic. Inflation of 8.7% in the UK for the past two months, with the “core” figure (which excludes volatile items such as food and energy) rising to 7.1% suggests that Lyon could be right.

He said: “Wage inflation is the most important component in driving higher prices on a more sustained basis. This is coinciding with slowing globalisation and increased intervention from governments, often in pursuit of more nationalist agendas. These factors are inflationary, and they come at a time when central banks have less room to manoeuvre. We expect that interest rates can only rise so far without severely injuring indebted economies.”

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Peter Spiller, of Capital Gearing, also thinks inflation is becoming embedded, which bolsters the case for owning inflation-linked bonds. He says climate change, the economic development of China, war in Europe and labour markets point to higher inflation.

Spiller said: “It appears that the relationship between capital and labour, and governments and labour, is shifting. In recent years it was commonly held that wage spirals could not occur because of the lack of unionisation. The relationship is probably the other way round: unionisation is a response to inflation, not its primary cause.”

Lyon says that after a disappointing year in 2022 index-linked bonds are now poised for better returns. He says that TIPS trading on positive real yields give investors two ways to win: price rises if bond yields fall if interest rates are cut, or if inflation expectations rise, which will increase the return from index-linked bonds.

“As it stands, index-linked bonds are pricing in a world where interest rates remain higher than they have been in over a decade, but where inflation returns to the Federal Reserve's 2% target. In such a world, real growth needs to be structurally stronger than it has been. We do not believe this to be consistent with the likely reality,” he said.

How to gain exposure

If you are convinced that allocating some of your portfolio to inflation-linked bonds makes sense, there are a number of ways to invest.

Probably the simplest option is to buy a tracker fund that owns a basket of such bonds. BlackRock’s iShares has a handy one-stop shop: the iShares Global Inflation Linked Govt Bond UCITS ETF. It owns 154 index linkers from the US, UK, France and Germany, among others.

For UK-only bonds, the iShares £ Index-Linked Gilts UCITS ETF will do the job, while US bonds are held in the iShares $ TIPS UCITS ETF.

But owning an ETF comes with the risk that bond prices will drop due to rising interest rates. While income may increase from rising inflation, bond prices are vulnerable, as we saw last year. Therefore, the risk is that falls in bond prices may continue to outweigh the inflation benefits.  

A way to mitigate that is to buy index-linked bonds directly and hold them to maturity. The price of the bond will revert to par as the maturity date approaches and the full principal is returned, meaning that investors able to hold bonds until they mature do not need to worry about changing prices. However, picking the right bond and understanding the complex calculations behind how principals and coupons as adjusted is not straightforward.

In my view, those who are pessimistic about inflation and economic growth are best served by owning a wealth preservation investment trust. Capital Gearing has the most invested in index linkers, at nearly 50%, and is on our Super 60 investment ideas list.

Manager Peter Spiller has more than 40 years investment experience and picks his bonds directly, with the ability to move into other markets that will protect investors. Since 1995, shares in his trust are up 11-fold compared with a 155% rise for RPI inflation in the UK.