On the face of it, buying index-linked exchange-traded funds (ETF) to insure against a revival of inflation seems sensible. After all, the retail prices index (RPI), which index-linked gilts track, is rising at more than 5% a year, way above the Bank of England's base rate of 0.5%. And the consumer price index (CPI) measure of inflation has overshot the Bank's 2% target in 17 of the last 24 months.
But we'd advise against buying the iShares Barclays Capital £ index-linked gilt ETF (LSE: INXG) at current price levels, for four reasons. Firstly, index-linked gilts are only guaranteed to give you an above-inflation return if you hold them to maturity. For shorter-maturity bonds, this may not be a problem. But if you buy longer-dated 'linkers' and half INXG's assets are in bonds with more than 15 years to maturity the price will rise and fall in the interim based on movements in so-called real yields.
And with real yields for long-maturity index-linked bonds driven to extreme lows by high pension fund demand, you'd be buying them at very expensive levels barely enough in yield terms, in fact, to cover the risk of sovereign default. If real yields were to return to the 4%-plus levels seen in the mid-1990s, any investor in long index-linked gilts would take heavy losses.
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Second, it's quite likely that the recent spike in UK inflation marks a short-term peak. A renewed fall in house prices, stagnant wages, huge industrial overcapacity none of this presages a real acceleration in inflation. And if Britain were to tip over into deflation, as seems very likely in parts of continental Europe, you'd want to hold conventional (fixed-rate) government bonds, not index-linked ones.
Third, there are more attractive inflation-linked bond markets elsewhere. Real yields in the US, Canada, and even Japan, among others, all offer better value than the UK. Even if it means taking some currency risk, it's worth considering a diversified index-linked bond fund, such as the iShares Barclays Capital global inflation-linked bond fund (LSE: IUS5), rather than the UK-focused INXG.
Lastly, consider the alternatives. For inflation protection if you believe prices are really about to take off gold, silver and certain equity ETF sectors (hard assets, utilities, for example) may provide a more cost-effective route to securing your savings' purchasing power.
Paul Amery edits www.indexuniverse.eu
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