How to inflation-proof your investment portfolio

Inflation has long been a threat to investors. If you want your savings to keep pace with the cost of living, they have to grow in real' terms after inflation. But what's the best way to beat inflation?

Buying the shares of leading companies is one method. Strong demand for these companies' products should enable them to raise prices at least in line with inflation, safeguarding their profits.

Property is another popular option, as rents tend to rise in line with inflation too.

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But shares and property are risky. Their prices fluctuate a lot (to use the City jargon, they're volatile') and you sometimes have to wait years for them to pay off. Investors who'd rather not take that sort of risk often buy government bonds instead.

These are seen as being about as safe as you can get: developed-world governments generally don't go bust, so you can be sure of getting your money back. And you're also getting a fixed interest payment over the period of the loan so it's nice and predictable.

The trouble is, inflation is toxic for such bonds. That £100 you invested in a bond ten years ago won't buy you anywhere near as much stuff today, because prices have gone up in the meantime. And your fixed-interest payments won't look very attractive either if inflation starts to rise while you're holding the bond.

To get around this, in 1981 the UK government began issuing index-linked gilts (linkers'). The interest payments on linkers, and the initial principal invested (usually £100), were adjusted for changes in the rate of inflation, as measured by the retail prices index (RPI).

In other words, the value of the original loan, as well as the interest payments made, goes up in line with inflation. Sounds straightforward. But beware: linkers can be trickier than you expect.

If you are to use them successfully in your portfolio, you need to know what causes their prices to change. So let's take a look at howthey work.

Here's the easy bit

So say you have a bond that pays interest in June and December. The cumulative change in inflation (since the bond was issued) to March and September of that same year determines your payout.

Say you invest £100 in a 20-year bond at 2% interest. Inflation then averages 3% for the next 20 years. After a year the £100 invested will be adjusted to £103, and the interest payment will be £2.06 (£2 + 3%).

If you hold the bond until it matures, you will get £181 back, and the final interest payment in year 20 will be £3.62. But if prices fell over the life of the bond in other words, if we got entrenched deflation rather than inflation you would get back less than £100.

Expected inflation and interest rates

But what happens if you buy a linker in the market and sell it before it matures? Just as with conventional bonds, you could easily lose money.

The price of linkers goes up or down, depending on what investors think will happen to inflation and interest rates. This makes sense. If investors expect inflation to rise, so will demand for linkers. If they expect inflation to fall, a conventional bond with its fixed interest rate will be more attractive.

So, smart investors work out what is known as the break-even' inflation rate. This is the rate of inflation at which an investor holding a linker and a conventional bond with the same maturity would get the same nominal (ie, inflation included) return from each (if held to maturity).

You calculate this break-even rate by taking the yield to maturity (redemption yield) on a conventional bond, and subtracting it from the redemption yield on a linker.

So, if a ten-year conventional bond yields 4% and a ten-year linker yields 2%, the break-even inflation rate is 2%. If you think inflation will average above 2% over that time, buy linkers.If you don't, buy conventional bonds.

Like all bonds, linkers are sensitive to changes in interest rates. The key is the change in the real' interest rate (that is, the yield on a conventional government bond, minus inflation).

If real interest rates fall (because inflation rises or interest rates drop), the price of linkers will rise and vice versa (yields and prices move like a see-saw when one side goes up, the other goes down).

Things can get a bit complicated when expectations for interest rate and inflation fluctuate, which unfortunately is what they tend to do. But in general, conventional bonds (those with fixed interest rates) tend to do better when interest rates and inflation are falling, which is often what happens in a recession. Linkers tend to do better if interest rates and inflation are rising.

So should you buy linkers now?

Break-even rates range from 2.7%-3.4%, depending on the maturity dates of the bonds in issue. If inflation ends up being lower than this, you will lose money (in real' terms) by buying linkers.

But if you think inflation will be higher than this on average over the life of the linker, then they could be worth buying. You can buy in via your stockbroker. Alternatively, buy an exchange-traded fund such as iShares £ Index-Linked Gilts ETF (LSE: INXG).