Protect your portfolio with index-linked bonds

Every week, a professional investor tells MoneyWeek where he'd put his money now. This week: Peter Spiller, chief executive, CG Asset Management

The past 15 years have seen an explosion of debt in the household sector and unprecedented growth in leverage in the financial system in the US and the UK. Financial conditions are so unstable that the Federal Reserve has intervened in ways unseen since the Depression.

There are three ways to resolve a problem of excessive debt: default, which suggests depression; socialising the debt, as illustrated by the Fed's purchase of part of Bear Stearns' portfolio; and inflation. The last seems likely to be the chosen route as the Fed prints money to shore up the financial system.

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So how can investors protect the real value of their portfolios? Two obvious assets are gold and index-linked government bonds. Gold has attractions, but may be too volatile for most. Index-linked government bonds achieve the aim of most holders of gold the preservation of the real value of capital. They also provide an income, as against the costs of owning gold.

Index-linked bonds are under-represented in most private portfolios. Given their characteristics both the principal and the interest payments are adjusted by the relevant price index they match the objectives of most individuals. And if held to maturity, the return on top of inflation is certain. That makes them ideal for part of any portfolio at any time, and today's uncertainties give them particular appeal. Recent history has suggested a powerful negative correlation with equities.

Unfortunately, redemption yields on the UK linkers are low by any standard. At the time of writing, the 1.25% 2017 UK index-linked gilt the obvious choice for a higher-rate taxpayer has a real yield of just over 1%, of which income tax will take almost half. Yields at the long end look too low to contemplate. The 1.25% 2055 has a real redemption yield of less than 0.7% before tax and a negligible return after tax. Even so, capital is being preserved in real terms. In the current environment, that could be the best outcome achievable.

However, overseas index-linked bonds offer better returns, particularly for longer dates. Long US Treasury Inflation-Protected Securities (TIPS) yield roughly twice the UK level, as do the equivalent in France and Germany. Even Japanese index-linked Government bonds yield more than their UK equivalents.

Of course, owning such bonds is subject to the risks and rewards of owning overseas currencies. But with sterling looking overpriced and correlated with financial markets, the foreign exchange exposure looks likely to add to the return. Indeed, such bonds look an excellent way of hedging against sterling, given the credit concerns inherent in large bank deposits.

For those investors who can own overseas index-linked bonds directly, interesting examples include the French 3.15% 2032, yielding 2.2% real; the Swedish 3.5% 2028, yielding 1.7%; and the Japanese 1.2% 2017, yielding 1.2%. The first two should be available through a decent broker, although Japanese bonds are harder for retail buyers to access. In practical terms, UK investors may prefer to own overseas index-linked bonds through a fund that can deal more efficiently and cheaply than individuals can, and where tax is less problematic.

These yields are at the low end of long-term ranges in normal times, which we assess to be broadly 2%-3%. However, with the policy response to an unstable financial system being to print money, real short interest rates may be very low, or negative, over the next year or two; long-term real interest rates can also fall. This would add to the return from the redemption yield, inflation and movements in the exchange rate.