Three ways bonds can help you beat inflation

Mervyn King had to write his second-ever letter to the Treasury this week, apologising for the Bank of England's failure to keep inflation close enough to its 2% target. But if there's anyone he should be saying sorry to, it's British savers. Surging inflation means that if you're a higher-rate taxpayer, it's more likely than not that your savings are losing value by the minute. Annual inflation, according to the Retail Price Index (RPI), hit 4.3% in May. That means a higher-rate payer needs around 7.2% (4.3%/0.6) just to stand still.

Can bonds help?

At a time of inflation, bonds are usually the last thing you'd want to invest in. That's because they mostly pay a fixed income. Say a gilt (government bond) costs £100 when first issued and pays 3.5%. If inflation rises, driving up interest rates, then the price of the gilt has to fall to maintain a decent yield after all, why would you buy a gilt paying 3.5% if your building society is offering 7%?

Another problem is that supply of gilts hasn't kept up with demand because rules on pension funding have forced institutions such as pension funds to pile into government bonds to match their future liabilities. That has driven gilt prices up and kept a lid on yields. For example, a two-year gilt currently offers a yield below 5%, despite the worsening inflation outlook. But there are other options in the bond universe here are a few that might just help you to beat inflation.

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Index-linked government bonds

Index-linked gilts pay interest that is linked to the level of RPI inflation as one rises so does the other. This means that prices tend to be relatively stable and, as with all gilts, the default risk is virtually non-existent. In The Price Report, PFP Wealth Management's Tim Price describes inflation-linked Government debt as "the least risky form of bond market investment, assuming a remotely inflationary future".

A good way of getting exposure that avoids having to pick individual gilts is via the Barclays iShares GBP index-linked gilt fund (LSE:INXG), which is up 13% over the last 12 months. Alternatively, the National Savings Bank offers three and five-year index-linked certificates, which currently pay an average rate of RPI plus 1.0%. That's the equivalent of nearly 9% for a higher-rate taxpayer. There is a maximum investment of £15,000 per issue.

Profit from falling bond prices

If you are happy with a bit more risk, you could exploit the fact that inflation tends to be bad news for fixed-income bond prices. Shorting bonds isn't easy, or recommended for the faint-hearted but now you don't have to, thanks to four ETFs that capitalise on falling US Treasury prices.

The Profunds Rising Rates Opportunity 10 (US:RTPIX), for example, captures the inverse movement on ten-year Treasuries. Each time they fall by 1%, the fund rises by 1%. More extreme, the Rising Rates Opportunity (US:RRPIX) offers 125% of the inverse movement in 30-year US Treasuries.

But for maximum leverage and lower charges with expense ratios of 0.95%, rather than a hefty 1.58% a better bet might be the Proshares Ultrashort Lehman 7-10 year Treasury (AMEX:PST) and 20+ year Treasury (AMEX:TBT). These offer twice the inverse performance of medium and long-term US government bonds respectively.

Neither tracks the inverse performance of US Treasuries perfectly since inception on 1 May, the seven to ten year has gained 2.5% against a 1.2% drop in the Treasury's benchmark, while the 20+ has risen 4.9% against a 2.4% drop. Yet Kiplinger's Elizabeth Ody still says the funds are "as precise a play as you'll find on rising rates".

What's more, as a British investor, you may also pocket an exchange rate gain on these dollar-denominated products if inflation forces the Federal Reserve to raise interest rates faster than the Bank of England (which would push the American dollar up against sterling). Of course, this could well backfire if US inflation suddenly subsides, sending the dollar down and Treasury prices up.

Permanent interest-bearing shares

If you are willing to leave the security of government bonds, permanent interest-bearing shares (Pibs), which are issued by building societies, currently offer a decent income yield. Although they are shares, Pibs are more like undated bonds. Most will not be bought back, or "redeemed" by the issuer, unless they are "callable" at a specified fixed date. Also, they pay no dividend. Instead, Pibs pay fixed interest in two six-monthly instalments.

As an example of the kind of yield Pibs currently pay, look at the Britannia 13% Pibs. On its current price of 175p a share, it's paying 7.43%. Other issuers typically offer between 7% and 10%. Better still, Pibs are Isa-eligible, so it's all tax-free. However, this income comes at a price unlike the Government, building societies can miss interest payments, or, in a worst-case scenario, go bust. In both cases, Pibs are ranked beneath outstanding debt.

Also, while Pibs can be traded on the London Stock Exchange, liquidity can vary, which partly explains the high yields. For a list of current yields and further information, contact broker Collins Stewart on 020-7523 8000.