Protecting Your Portfolio from Inflation – Index Linked Gilts (Linkers)

As a person who is not in debt and is saving hard for Retirement I am very conscious of the need to protect the purchasing power of my Retirement Investing Today Portfolio from the ravages of inflation.  Once I’ve done this I then need to work out how to get a real (after inflation) return.

If I am a debtor then inflation can help me as the real value of my debt becomes less as every day passes, however the opposite is true if you own assets.  Additionally, in a relatively low inflation environment, like we find ourselves today, it can be easy to ignore it.  In my opinion we just can’t afford to.  Even a small amount of annual inflation will wreak havoc on a non inflation protected portfolio over a relatively short period of time.

My chart below shows in graphical form the damage that inflation can do to your purchasing power if you don’t protect yourself from it.  This shows the purchasing power of £100 if placed under your mattress in July 1982, July 1992 and July 2002.  These are not made up numbers but instead reflect UK reality with the chart developed using the Retail Prices Index (RPI) as published by the Office for National Statistics.  £100 in July 1982 only has the purchasing power of £33.82 today.  £100 in July 1992 only buys £57.33 worth of 1992 goods today.  What is disturbing though is that even over a relatively short 10 year period (July 2002) purchasing power has been eroded significantly and buys only £72.65 worth of 2002 goods.

Click to enlarge

As a person working towards Early Retirement in my early 40’s I may need to protect my purchasing power for 50 years or more.  If my savings are not to be eroded I believe I must therefore take Inflation very seriously and protect myself wherever possible.

But deflation is just around the corner

If I position myself for inflation protection then should we end up with a deflationary environment there is a risk that my portfolio will underperform by placing all my bets on inflation.  While deflation may occur I believe that our Government and Policy Makers will do everything in their power to ensure we have inflation, even to the point of currency destruction.  Why do I believe this?

Example 1.  History.  The chart below shows how the Retail Prices Index (RPI) inflation measure has changed in the last 60 years.  While there have been periods of deflation, including the last few months, over the long term the trend is very much one of inflation.

Click to enlarge

Example 2.  Inflation steals from savers and helps debtors.  Who is the biggest debtor in the UK today?  The UK Government.  So why would they want deflation?

Example 3.  You can’t tax deflation.  Inflation provides a brilliant opportunity for the UK Government to steal earnings and investments through taxation that can’t occur in a deflationary environment.  The brilliant thing about is that the vast majority of people don’t even know it is occurring.  Let’s say you have nominally £10,000 worth of assets which over a few years due to inflation only increases to be worth a nominal £11,000.  You may as an individual then have to pay either £180 (18% Capital Gains Tax) or £280 (28% Capital Gains Tax) to the Government depending on your tax band (ignoring Tax Free Allowances for Capital Gains Tax) were you to dispose of this asset.  This means that in Real (ie maintaining purchasing power) terms you are actually going backwards.  What about if we were to see deflation and those assets become worth a nominal £9,000?  In this instance the Government gets nothing and your purchasing power is maintained.

Example 4.  Do as I do and not as I say.  The Bank of England says that they set interest rates to keep inflation low to preserve the value of your money.  Their Monetary Policy Framework tells us that “The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target of 2%.”  So that’s what they say now what do they do.  Well inflation has now been above their 2% target since December 2009.  Additionally, while telling us they will keep inflation low to preserve our money behind the scenes in their own pension fund (the table below) they have at least 94.7% of their assets protected from inflation.

Click to enlarge (Source: Bank of England, Pension Fund, Report and Financial Statements 2012)

   

UK Index Linked Gilts (Linkers)

The Retirement Investing Today portfolio is based on a fairly typical asset allocation model which I have then slightly modified to suit my own needs and to try and squeeze some extra performance.  This is how I built my original portfolio.  The basic two building blocks chosen were “high risk” equities and “low risk” bonds.  Within the equities portion I feel by default that I am reasonably well protected with equities (companies over the long term should be able to raise prices in line with inflation), property (rent should be able to be raised in line with inflation) and possibly even my commodities holding (now only gold) protecting me from inflation.  It is the “low risk” bonds portion where I had to do some thinking to protect myself from inflation.

A traditional portfolio would probably likely hold Corporate Bonds and/or Government Gilts plus an Emergency Fund of Cash.  I’m no different with an Emergency Fund of Cash which I know is being eroded by inflation.  Where I do differ is that I no longer hold any Corporate Bonds or Government Gilts.  Instead the remainder of this portion of my portfolio is built up using NS&I Index Linked Savings Certificates and UK Index Linked Gilts.

UK Index Linked Gilts are issued by the UK Government.  The way that they operate is that, unlike traditional Government Gilts, both your capital value and the interest paid are linked to the Retail Prices Index (RPI). 

Let’s run a very simple example.  Let’s say you buy £1,000 worth of a 10 year Index Linked Gilt which pays a coupon of 0.5% (the yield after inflation which is quoted in the title of the gilt).  If inflation is 3% over that 10 year period then when the bond matures the Government would hand you £1,344 (=£1,000x(1+3%)^10 or =£1,000x(RPI At End of Period)/(RPI at Start of Period)) back.  Your 0.5% coupon which is also paid during the time you own the bond will also pay you 0.25% of the increased capital amount every 6 months ((=0.5%/2)x((RPI at Coupon Date)/(RPI at Start of Period))).

They are actually more complex than this as there are lags of either 3 or 8 months over which inflation is calculated, rounding conventions you should be aware of plus an order more complexity appears if you buy a gilt already in issuance or sell before maturity to name just a few items of complexity.  If you are interested in UK Index Linked Gilts I urge you to really understand how these work to avoid disappointment.  A good starting point would be the fantastic book by Tim Hale : Smarter Investing Simpler Decisions for Better Results and the UK Debt Management Office (DMO) website.

    

Conclusion

Of course Index Linked Gilts could lose out when compared to other Bonds or other “low risk” investments.  Only history will tell what was the best choice.  In the meantime on Thursday I converted 0.8% of my total portfolio value from cash to Linkers to bring my total holding to 3.3%.  This may not sound like much but over the coming months and years I expect this to grow quickly as both my NS&I Index Linked Savings Certificates begin maturing after their reinvestment period in October 2013 plus I continue to save at a very high rate with no opportunity to invest in new NS&I issues.

The most cost effective way I have found to hold my Linkers is:
-    With my Sippdeal SIPP I have access to Vanguard funds and so buy the Income variant of the Vanguard UK Inflation-Linked Gilt Index Fund which has a TER of 0.15% and a Purchase Cost of 0.20%.
-    Within my TD Direct ISA I don’t have access to Vanguard and so buy the iShares Barclays Capital £ Index-Linked Gilts (INXG) which has a TER of 0.25%.

How are you protecting yourself from inflation?  Are you protecting yourself from inflation?  Do you think we will see inflation or deflation?  I welcome answers to these questions or any comments to help us all learn below.

As always DYOR.