Many investors hold fixed interest assets in their portfolios, that is, gilts, index-linked gilts and corporate bonds, either directly or via a professionally managed fixed interest fund. It is generally true that the more cautious the investor or the investment portfolio, the greater the percentage of fixed interest that is held.
This does not mean, however, that fixed interest investments do not pose a risk to investors and a major part of that risk for the majority of fixed interest investments is inflation.
According to the data produced by the Office for National Statistics, inflation as measured by the Retail Prices Index (RPI), has been on a downward trend since the 1970s and is now in negative territory. Holding fixed interest investments, particularly those with a long term, has generally been beneficial for investors during much of this period. Investors have not only received a decent level of income (the ‘coupon’) but there has been some capital growth as well, which in some years has been well into double figures.
The UK economy is coming out of a lengthy recession but is lagging most of the developed countries in the world and a number of the undeveloped ones as well because we, as a nation and as individuals had simply build up far too much debt. Whichever party is in Government by next May they will want to make us all feel better by seeing the value of our houses and incomes rise. At the same time they will need to take tough measures to reduce the budget deficit which is now running at 13% of GDP.
A number of economists believe that there is a simple solution to these various Government desires, whichever party is in power – inflation. By creating a decent level of inflation we will all feel better because our houses will seem to have increased in value, our incomes will rise (unless we have already retired) and our mortgages will appear to shrink in real terms. The mountain of Government debt would also be reduced in real terms as inflation takes hold.
Although inflation may not seem to be an issue while the RPI is negative it is not so much the fact of inflation that will destroy the capital value of fixed interest investments but the expectation of inflation, and financial markets are apt to create such financial tsunamis without warning.
The value of any investment is what someone else is willing to pay you for it. You may, for example, hold £50,000 of fixed interest debt which has been issued by the Government (a ‘gilt’) or a major corporation (a ‘corporate bond’) on which you have been promised 5% per annum for the next 10 years. However, if inflation starts to come back into the system without too much of a check by the Government and interest rates go up then you may find that new fixed interest debt is being issued at 7% per annum for the same period. In very rough terms this will reduce the current value of your fixed interest investment to £35,714.
We are not suggesting that you get out of all of your fixed interest investments as these are a necessary part of any balanced or lower risk portfolio, but you should be reviewing them. In particular you might want to sell your longer term direct holdings and buy shorter term where inflation is less of an issue. If you invest via gilt or corporate bond funds then you should check that these are of the ‘strategic’ variety, in other words the fund manager has the ability to reduce the ‘duration’ of the portfolio and in the case of gilt funds particularly, that the manager has the ability to move heavily into index linked gilts which will at least offer more protection for your capital.
Just as there is a flight to the larger, more secure, companies when stockmarkets are falling, so there tends to be a flight to the more secure issuers of debt when inflation is rising. The reason is liquidity. If investors want to get their money out then they had better be holding Government stock or that issued by AAA rated corporations. So another check should be on the proportion of lesser rated stocks in any fund that you hold.
One of the newer investment groups, City Financial Investment Company Limited, has two very useful fixed interest funds which are being actively managed to take full account of the possibility of increasing inflation, that is, their Strategic Gilt Fund and their Global Bond Fund. The Strategic Gilt Fund uses gilts and index linked gilts in the same fund, is currently keeping the durations short and can use options (specifically ‘covered calls’) to increase returns. Such options pose no additional risk to the fund as they are effectively selling excess growth on fixed interest debt which they already hold in the fund. The Global Bond Fund utilises the fact that the UK now accounts for only 6% of the global bond market.
Investors often choose lower risk investments to keep their capital secure but overlook the need for what has been called ‘purchasing power preservation’. As an aside, if inflation does come back into the system then holding money on deposit, apart from that necessary for an emergency fund, will not fulfil the need for purchasing power preservation but will, in most cases, guarantee a capital loss in real terms.
The cautious portfolios that we use include healthy amounts of equities (ie stocks and shares) not because we are trying to stop our clients from sleeping at night but because we are concerned to make sure that the real value of their investments is maintained in the long term. For further information on our investment proposition see www.arch-fp.co.uk/investment_proposition.php
In summary, the present bull run in fixed interest investments could continue for a little longer, but once sentiment turns and the shape of what is called the ‘yield curve’ changes, it will be too late for investors to move out without capital loss. We would encourage investors to let us review their fixed interest investments now in the light of their overall portfolio.