How to protect your wealth from inflation

As inflation rises, your profits could rapidly be eroded unless you put your wealth to work. Here, the MoneyWeek team looks at the best ways to prepare for inflation.

The inflation-deflation debate has been raging since the financial crisis erupted back in 2008. Would Western economies follow Japan into a deflationary slump? Or would rapid intervention and rampant money printing by central banks manage to push up prices, even with a broken banking system?

To all of us here at MoneyWeek, it's looking increasingly like inflation is winning, certainly here in Britain. Consumer Price Index (CPI) inflation has been above the Bank of England's central 2% target for 41 of the last 50 months. And Retail Price Index (RPI) inflation arguably a more accurate measure of the cost of living is running at 4.6%.

Avoiding Japan's fate may seem like good news. But just because prices are rising, that doesn't mean the economy is recovering. Britain may well be heading for the worst of all worlds stagflation. As Allister Heath points out in The Spectator, the much-hyped spending cuts aren't the big problem facing most voters. The real issue is that while prices are rising, their wages aren't. If you strip out the public sector, average earnings are up by just 1.2% this year. Indeed, according to professional services group Deloitte, says Heath, "the last time ordinary folk were being squeezed as much by inflation and tax hikes was in 1982 at the height of the recession and Falklands War". With a 20% hike in VAT on the way, the pressure on both consumers and prices is only going to get worse.

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Despite the Bank of England's best attempts to convince us that deflation is still a possibility, the prospect of a 20% hike in VAT from next year makes that unlikely. So it's more important than ever to make any money you still have work for you. But with interest rates at record lows, what is the best way to protect your wealth from the ravages of inflation? Here, we take a look at five popular ways to generate an income, and rate them in terms of both the potential risks to your capital and potential rewards (five stars = high, one star = low).

1. Blue chips

Risk ****Your capital is at risk, but it's easy to sell out of liquid stocks like these.Reward *****Yields are relatively high and defensive stocks look good value.

One place to hunt for income is on the stockmarket. The average FTSE 100 stock is yielding 3.3% (that's taking dividend payouts as a percentage of share prices you can learn more about dividend yields here). That's only a bit higher than the current UK inflation rate. But because tax on dividends is calculated differently to tax on interest income, this is better than it looks. As a basic-rate taxpayer, you have to pay 20% on interest from a bank account; 40% taxpayers pay 40%; and 50% payers have to shell out 50%.

But with dividends, if you're a 20% taxpayer you pay 10%. If you're a 40% payer you pay 32.5%. If you're a 50% payer you pay 42.5%. Better yet, the quoted yield on individual shares already takes account of tax paid at 10%. So if you're a 20% taxpayer there's no more to pay. And if you're a 40% taxpayer there's only another 22.5% to pay. So despite the risk to your capital involved in buying shares, it does feel a little foolish to have all your money sitting around losing purchasing power in cash.

Of course, you need to be selective about what to buy. We've been very wary about the broader UK stockmarket. And we're getting more worried the higher it goes. There are far too many unknowns about how fast if at all the economy will expand. So we'd avoid 'cyclical' stocks those which depend on economic growth to make their money. Instead, as we keep suggesting, you should buy defensive (or 'quality') blue chips ie, stocks that don't depend on the economy growing with relatively safe, high yields.

And if you want a really tasty yield say 5%, about 50% above the average the number of available stocks comes right down. Judging by last year's payouts, only about 10% of FTSE 100 stocks currently fit this particular bill. The good news is that they're almost all defensives, which brings us to the next big plus point about the stockmarket as a potentially inflation-busting income source. Even if the economy goes nowhere, but the cost of living still rises, some of these defensive firms will still see their profits grow, which means their dividends can too. For example, regulators will probably allow utilities (electricity and water suppliers) to keep hiking prices in line with inflation to raise cash for investment in their networks. That's good news for shareholders.

Another sector worth a look offers even higher yields insurance. The industry accounts for four of the eight highest-yielding FTSE 100 stocks just now. That suggests that investors are worried about whether these firms can maintain their dividends. Yet the sector's balance sheets are among the most cash-rich around, while dividend cover (the number of times dividend payouts are covered by net profits) is healthy too. Indeed, analysts expect dividends to rise next year.

The insurance industry is simply out of favour with the market because it's part of the financial sector. That seems unfair it was the banks, not insurers who were really involved in the financial crisis but it's a great opportunity for investors who are prepared to take a contrarian view. By buying when a share is unloved and cheap, you can lock in an inflation-busting and potentially rising yield straightaway. And at some point in the future, you're likely to profit when the market becomes keen on it once again.

General insurer Aviva (LSE: AV) stands out from the rest in terms of individual stocks. It's on a more-than-twice covered prospective yield of 6.4%, forecast to rise to 6.8% in 2011. And on a p/e of just seven, trading in line with book value that's all net cash, it's great value too.

Or if you prefer to spread the risk within a fund (clearly investing all your available money in just one stock is not a sensible idea), the Edinburgh Investment Trust (LSE: EDIN), run by Invesco Perpetual's Neil Woodford, is on a historic yield of 4.6%. Alternatively, the Dunedin Income & Growth Investment Trust (LSE: DIG) yields 4.85%. Both invest mainly in higher-yielding British blue chips.

2. Prefs, Pibs and Cocos

Risk ****Prefs and similar instruments rank above ordinary shares, but are still pretty low in the pecking order. Liquidity can be poor.Reward ****Yields are temptingly high.

One alternative to blue-chip shares is preference (or 'preferred') shares. These are issued by larger companies but in much lower volumes than ordinary shares. While dividends on ordinary shares can be postponed or cut at the decision of the directors, preferred shares (Prefs) pay a fixed dividend at a pre-set rate, similarly to a bond. In theory this could be deferred too, but by law, firms normally have to settle preference dividends before paying ordinary dividends. So there is more certainty on both the amount and timing of any dividend payment with Prefs. That's the good news. The problem is that not all firms issue them and those that do tend to issue relatively few. So liquidity can be low always check the bid-to-offer spread before buying (that's the gap between the buying and selling price).

For the brave, Nick Louth in the Financial Times likes the Raven Russia (LSE: RUS) preference shares. These yield over 11%, based on the rental income the company gets from a string of Russian warehouses. Or to spread risk, you could buy a fund. One of the simplest and cheapest is an exchange-traded fund such as the iShares S&P US preferred stock (NYSE: PFF). It tracks the performance of a group of US preference shares. It delivered a yield of around 7% in the 12 months to the end of September.

Similar income generators that are often overlooked by investors are permanent income-bearing shares (Pibs). These are typically issued by building societies and pay a fixed rate of interest, rather than a dividend. In effect they are IOUs, little different in principle to corporate bonds. As such they do carry risks if an issuer goes bust you may not get your money back. And as Northern Rock showed back in August 2009, interest payments can sometimes be suspended. Pibs are also pretty illiquid the best bet as a retail investor is to contact broker Collins Stewart, while you can find a full list of Pibs here. Current yields from some solid names are pretty tempting. For example, Skipton Building Society 6.875% 2017 offers a yield of just over 8%, while Kent Reliance 7 7/8% 2014 offers just under 9%.

A similar option we're not so keen on are enhanced capital notes (ECNs), or contingent convertibles (Cocos). Investors who held preference shares in Lloyds may have come across ECNs, even if many other retail investors haven't yet. As part of a big refinancing exercise at the end of last year, the troubled bank offered its preference shareholders and anyone with subordinated shares the chance to switch into ECNs. The deal which raised around £8.5bn in total involved existing investors swapping their securities for bonds offering a high fixed coupon over a defined period. The catch is that should the bank's tier-one regulatory capital ratio (a test of the minimum amount regulators require the bank to hold as a safety buffer) fall to, or below, 5%, the bonds could be forcibly converted into equity. This is a general feature of Cocos an investor starts with debt that may convert to equity if a specified event occurs.

Other banks hit hard by the credit crunch have taken an interest in issuing Cocos. So why are we wary? Mainly because these instruments are complex (they combine features of debt and equity) and largely untested the market is still small. Swapping an existing instrument for a Coco might make sense for investors aiming to cut their losses, but parting with hard cash to buy one is far riskier. So even if other banks issue Cocos, we'd be wary until the market is more mature.

If you are happy to live with the risks, one of the best bets could be the 13.5% 2025 Cocos issued by Yorkshire Building Society, yielding around 11.5%. Just bear in mind that these securities can be forcibly converted into shares (with no guaranteed dividend) should the society's tier-one capital drop to 5%. However, as Louth notes, since the society's rate stands at double this (when you include Chelsea Building Society, which Yorkshire recently took over), "I do not see this being an issue".

3. Buy-to-let

Risk ****Unless you have a huge amount of capital, it's hard to build a diverse portfolio. And you can't sell in a hurry.Reward *Voids and rental hassles can cut yields very rapidly.

The UK letting market is booming. Tenant demand reached new heights in the third quarter of 2010, with more than 61,000 new tenants registering for rental accommodation. That was up 19% on the second quarter, says Countrywide.

In London, one agent claims his landlords are doing so well that the market seems almost back to its "pre-crunch glory days". Add that to average net yields on UK residential property of 4.5% or so (on Investment Property Databank numbers), and you might wonder why we don't suggest that anyone looking for yield rush towards the buy-to-let market.

The first reason we don't is that we aren't sure rents will keep rising. They may fall instead. Right now there is a shortage of rental property, but a glut of property for sale. The last time this happened, sulky sellers, keen not to be over-run with bubble-level offers for their most prized possessions, withdrew from the sales market and let their houses instead. The result? Rents fell sharply in 2008.

The reforms to housing benefit should also affect the market: the high rents paid by social tenants have been pushing rents up across the board, so cutting them should in part reverse the process. But even if rents did keep rising, it wouldn't necessarily follow that being a small landlord would be a clever way to make a real return. Add in the costs of repairs and refurbishments. Then take account of void periods and of the chance of having a bad tenant, and it doesn't take much to push someone with only a few properties into negative cash flow and from there to disaster. If you had 50 properties and operated in scale you had dedicated handymen and a diversified portfolio it might work, but the truth is that over almost any period of time the average buy-to-let investor has ended up relying on capital gains, not rent, to provide his returns.

That brings us to the final reason for being wary of the sector. Even if you could be sure you would end up cash-flow positive, you most certainly couldn't be sure of hanging on to your equity. You could argue for hours (and we do) about whether house prices are still in bubble territory or not. But whether they are affordable or not is entirely by-the-by for prices. With the mortgage market still very tight, the housing market is inaccessible to most people, and it'll stay that way. The most recent note from the Council of Mortgage Lenders (CML) points out that while there are occasionally signs that things are loosening a little, "the UK banks have very significant calls on their funding over the next 12 to 15 months as they repay the Bank of England the funds lent during the 2008 crisis". That means fewer mortgages, not more.

And just as demand is falling, supply is rising. London agent Ed Mead notes that in the six months to September the number of people registering to buy with his agency was down 14% on the same period in 2009, while the stock of property that came on in September was up 31%. That kind of mis-match suggests to us that house prices have nowhere to go but down. And that the buy-to-let market is best avoided. The yield isn't worth the risk to your capital.

4. Bonds

Risk ***Less risky than stocks, but by and large the higher the yield, the more chance you have of losing your capital.Reward **Yields are low on all but the dodgiest debt.

Inflation is traditionally bad news for bonds they pay a fixed income, and so its value decreases as inflation rises. Yet bond funds have proved very popular with retail investors since the credit crunch. That's partly down to lingering fears of deflation, but it's also because investors are assuming that another bout of quantitative easing (QE) will see the Bank of England and the Federal Reserve buy even more of their own governments' debt, in order to push up the prices of other assets, including bonds.

However, it strikes us that this is 'greater fool' investing at its worst. Sensible investors don't buy an asset because they hope someone will come along and buy it off them for more money. If you look at the fundamentals, there are many warning signs that bonds in general are becoming overly popular. Yields on the lowest-rated corporate bonds (junk bonds) are at their lowest levels since before the crisis. Meanwhile, investment-grade debt is setting new records. As Max King of Investec points out, IBM recently issued three-year debt with a coupon of 1%, "the lowest ever on corporate bonds". The 100-year bond has also returned "past issuance of these has marked market peaks".

The reality is that firms are getting good deals from lenders here that's good for the firms, but not so good for the people lending the money. If you're betting on a future that holds stagflation, you should steer clear of bonds.

5. Cash

Risk *Your capital is as safe as it can be (just keep to below the £50,000 compensation scheme limit).Reward *You're unlikely to find a rate that beats inflation.

Most savings accounts lose you money rather than make it. A new report from Which? points out that half of the 1,200 easy-access and notice savings and cash Isa products available pay a pitiful 0.5% interest. For the value of your savings even to stand still, you need an account that pays more than 3.1% interest before tax (and that's using the Consumer Price Index rate). So a basic-rate taxpayer needs a rate of 3.9% and a 40% payer needs 5.1%.

The best rate you can get just now is 4.55% for the AA's five-year bond. But we'd be reluctant to go for that. If inflation really takes off, the Bank of England could be forced to hike the bank rate (or 'base rate', as we used to call it), so it's risky to lock your money up for too long. On that basis, the best rate available is 3.5%, which Tesco, Santander and NatWest all offer on their two-year bonds. That will allow a basic-rate taxpayer's money to grow just but those paying higher-rate income tax will still have a shrinking savings pot.

So a better option is to go for an individual savings account (Isa). As the interest you receive on money held in an Isa is tax-free, you only need a rate of 3.1%. Chelsea Building Society's Fixed Rate e-Isa is a two-year fixed term account paying 3.25%. If you aren't willing to lock your money up for that long, then it is a question of minimising your losses. Marks & Spencer Money offer a one-year Isa paying 3%. Or you can get instant access in return for a 2.85% interest rate with Halifax and Principality Building Society.

This article was originally published in MoneyWeek magazine issue number 510 on 29 October 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.