How to invest for ‘goldilocks’ inflation

On Monday we looked at how to get a surprisingly handsome 9% yield out of Lloyds’ preference shares. From where I’m standing, they look an awful lot better value than the ordinary shares (ords) most punters go for.

But as one reader pointed out, preference shares (prefs) are more like bonds than shares. And bonds don’t do very well during inflationary periods. Good point.

I want to look at that point in a bit of detail today. I’ll show you why this preference share could be OK, even if we hit rising inflation. We’ll cover an incredibly important concept for anybody in the market for fixed income investments, whether it’s preference shares, bonds, or even a fixed term deposit at your high street bank.

How inflation massacres bonds

If you buy a 30 year government bond (or gilt) today, you’ll get a 4% yield for your troubles. Not very tempting. Still, it seems popular with the guys in the City right now. Each to their own, I suppose!

When you factor in inflation of 2%, the real yield falls to just 2%. And if inflation takes off, you could be looking at negative real returns.

What’s more, if inflation really gets cracking, the Bank of England will have to raise interest rates to try to keep a lid on it. Then suddenly any investment with a fixed return is going to look deeply unattractive. Gilt prices may fall a long way.

This is the classic inverse relationship between bonds and inflation. Inflation up; bonds down.

But some bonds are more sensitive to changes in inflation. For instance, a one-year bond won’t be much affected by a rise in inflation – you’ll be getting your money back in a year anyway. Whereas if you’ve got a 30-year bond and inflation takes off, then you’re in trouble. You could be stuck with your miserable 4% return for years. All you can do is sell your bond – but nobody’s going to give you much for it.

Now seeing as the Lloyds pref is irredeemable (ie there is no end date), then you would expect this stock to be very sensitive to rising inflation.

And sure, it is. But this particular bond has at least one redeeming feature. And this feature is a great help when it comes to rising inflation. Allow me to explain.

Outrun inflation with a big yield

Though this share has a fixed dividend, it is at least paying a great deal more than the 4% its government equivalent pays. At today’s price of £1.05, the 9.25p fixed dividend comes in with an annual yield of just under 9%.

You don’t need to be a genius to see that inflation can go up quite a way before we’re actually into negative returns on this bond.

But there’s more to this high coupon than meets the eye.

If you put down £1,000 on this 9% share, then you’ll be getting a rather handy £90 a year. Add up these interest payments and you’ll get your £1,000 back after about eight years. That is, assuming dividends are reinvested for the same 9% return.


Now consider the government bond paying 4%. With this bond it’ll take nearer 18 years to get your money back. And the longer it takes to get your cash back, the more at risk you are to an inflationary storm.

But an inflationary storm is a special situation, one you need to think ‘outside the box’ for. That’s where a smart alternative investor like Simon Popple comes in.

And bear in mind, I’ve only considered the yield here. Rising inflation will whack the capital value of the bond, too - there’s nothing we can do about that. That’s fixed income investing I’m afraid.

But I hope you can see that a large yield could make a big difference should we hit an inflation problem down the line. The sooner you earn your money back, the less risk there is of inflation giving you a whack over the head.

But of course, Lloyds isn’t paying this handsome dividend yield out of kindness. It’s because there’s risk involved. You may never get your money back at all!

But again, an inflationary environment may not be all that bad.

The ‘goldilocks’ inflation rate for Lloyds’ pref shares

So it comes down to yield on the one hand, and inflation on the other. I guess the main reason people are petrified about inflation is because of central bankers’ experiments with money printing.

You see, central bankers hate deflation. That’s because it would be terrible for the banking industry. Basically, deflation makes loans (the backbone of the industry) more difficult for borrowers to pay back (think about it as the opposite of inflating away debts). Deflation increases defaults and bank losses mount. That’s why the central banks are doing everything they possibly can to keep the system away from deflation and into inflation.

Now let’s think about this logically. If part of the reason why Lloyds has to pay 9% interest on its debt is down to a deflation risk, then surely a little bit of inflation is going to be good for it.

If inflation helps Lloyds then its credit risk might not be so bad.

What I’m saying is that a little bit of inflation would do Lloyds good. If it keeps bad debts at bay and helps Lloyds profits grow, then preference share holders should welcome a little inflation.

Of course, this is a goldilocks scenario – we don’t want it too hot, nor too cold. Too much inflation and the real value of the dividends is eroded; too little and the whole banking industry may be at risk.

Better than ords, but not perfect

As I said on Monday I’m not particularly enamoured by the banking industry. But a huge number of investors own Lloyds ordinary shares. And my point is that I think they own the wrong class of Lloyds share.

As I’ve shown, Lloyds pref shares make more sense than ords. As part of a balanced portfolio seeking income, they may not be a bad bet. Yes, it’s true that if we hit severe inflation these prefs would start to look bad value compared the ords.

But the prefs do have a couple of redeeming features that other fixed interest investments lack – starting with that juicy 9% yield.

• This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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6 Responses

  1. 24/10/2012, Daniel Victor wrote

    A third problem – in addition to inflation and risk – is tax inefficiency.If you wind up with too much income,it pushes you into a higher tax bracket.Then you wind up paying more tax on your capital gains and your dividends.

  2. 24/10/2012, bengt wrote

    Daniel

    Sure – too much income is generally a problem for most people!

    But seriously, pref share dividends are pretty handy for most investors as far as tax goes…

    For basic rate payers, there’s nothing more to pay, and it’s pretty tax efficient for higher rate payers too (you pay less tax than with an equivalent bond).

    If it’s still a problem, maybe pop it in an ISA, or a SIPP?

    Bengt

  3. 24/10/2012, Gerry wrote

    Hi Bengt
    Another issue with Lloyds prefs which also has to considered .Although the current climate is not so fraught its only 3 years since Lloyds put holders of their prefs (and i was one of them) into a virtual lottery when they were prevented from paying divs on prefs they issued enhanced capital notes (ECN’s)on their selected tranch of prefs if you didnt hold the specific selection it was “tough”.It could happen again.
    Regards Gerry Cotterill

  4. 24/10/2012, Peter wrote

    My real worry here isn’t the “goldilocks” inflation scenario, but a return of the 1970s inflation, which, of course, whilst great for debt, murdered those on fixed incomes such as Lloyds prefs.

    And with the amount of QE out there, I fear the “goldilocks” scenarios risks being as much a fairy tale as the one with the three bears.

    Which probably makes me an inflation bear.

  5. 25/10/2012, alan wrote

    when do they pay out the divi.

  6. 25/10/2012, Cal wrote

    Something that does seem to have been missed is pointing out that these are “Non Cumulative”. In other words if Lloyds gets into trouble again (and let’s face it that is a distinct possibility) they can stop paying out again and that income is lost forever.

    Compare that to preference shares from the insurers such as RSA which are “Cumulative”. In other words if they miss any payments they have to catch up and refund you later. A benefit that is well worth the 1-2% lower yield in my opinion.

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