Three ways to beat inflation

Royal Bank of Scotland (RBS) wants your money. And lots of investors want protection from inflation. So the latest inflation-linked retail bond launched by RBS on the London Stock Exchange (ISIN GB00B3YYW134) looks like a match made in heaven. But is it really as good as it looks at first glance?

Why inflation is still a worry

With Europe paralysed over what to do about Italy and the rest of the eurozone casualties, you could be forgiven for thinking that the world faces a slide into recession and deflation. But writing off inflation would be a mistake. Central banks have been pumping in huge amounts of extra liquidity via record low interest rates and quantitative easing. This won't be easy to reverse if inflation does take off. Indeed, plenty of critics accuse central banks of deliberately engineering inflation to ease the debt burden on indebted governments (see below). Here in Britain, inflation is already a fact with the October Retail Price Index (RPI) up 5.4% on last year, anyone with cash in the bank is seeing its real value eroded at a painful rate.

What RBS is offering

So what's the latest deal from RBS? Some careless writers are referring to the new bond as offering inflation plus 2%'. That's a bit misleading. The deal is this. For the seven years until the bond matures, you receive a gross annual coupon of 2% (ie, for every £100 you buy, you get £2 a year). On top of that, the capital you invest is linked to the RPI. So when the bond matures, you get the nominal value back plus an adjustment to reflect the change in RPI over the seven years. So as the RBS fact sheet points out (you can find it at UKmarkets.rbs.com), should the RPI rise by 20% between now and September 2018 (the final fixing' date for the purposes of calculating any inflation adjustment), you'll get back £1,200 per £1,000 nominal you own.

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If that sounds tempting, here are some reasons to be wary. Firstly, to earn a return of 20% on top of your £1,000, the RPI will needto rise from 237.9 in September 2011 to more like 285.48. That's possible, but in the interim, inflation could do almost anything. So it's a high-risk proposition. If RPI stays where it is or drops, you get back just the £1,000 nominal value. That means your only return will have been a measly 2% a year which is subject to income tax (unless you put the bond in an individual savings account).

There are other catches to watch for. You get the inflation adjustment at the end of the life of the bond in one lump, so meanwhile you are not earning much income, should inflation take off. That makes this bond a poor choice for anyone looking for a regular income stream. Another problem is that this bond is not covered by the Financial Services Compensation Scheme (FSCS) should RBS default. At the moment that's unlikely as the bank is backed by the taxpayer via the government's stake in it. But that may not be the case in seven years.

Then there's the risk to your capital should you want to sell up early. Bonds can go down or up in price between the point you buy and redemption. By selling early, not only will you miss out on the capital uplift for inflation, but if you sell for less than £1,000 (the minimum subscription), you will lose some of your initial capital. So there are several reasons why this isn't the best offering around for investors seeking inflation-protection. Indeed, it isn't even the best offering from RBS.

What to buy instead

If you can stomach lending your money to a bank given all the bad news pouring in from Europe, then another RBS bond offers better terms. An earlier inflation-linked bond (ISIN GB00B4P95L57) offers 3.9% fixed or the 12-month change in the RPI if that is greater. So should the annual RPI rise by, say, 5% between quarterly measurement dates (ie, the annual rate is rechecked every quarter), you get a 5% coupon (pro-rated down to one quarter). But should it rise by less than 3.9% or even fall, you get the fixed 3.9% (again pro-rated quarterly). Provided RBS is still around in November 2022, you get the full nominal value back (£100).

If you want a straight inflation tracker, try the Post Office inflation-linked bonds. The latest deals are not as good as some previous ones, but you can still get the RPI plus 0.25% over three years, or RPI plus 1% if you lock up your money for five years.

How inflation erodes the value of debt

If you owe £1,000 and inflation is zero, in a year's time you will still owe £1,000 in nominal (before inflation) and in real (after inflation) terms. But if inflation is 5% and you repay no capital in the first year, the debt's nominal value is still £1,000 but its real value is more like £952 (£1,000/1.05). So a bit of inflation suits borrowers, as long as they can afford their interest bills. Sadly, it stuffs savers who see the real value of their deposits eroded.

This article was originally published in MoneyWeek magazine issue number 564 on 18 November 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.