Rising inflation has sparked much debate about how high it will climb and for how long. Inflation in the UK jumped to 2.1% in May, over the Bank of England’s 2% target for the first time in two years.
The Bank has since warned it will rise above 3% this year, but believes that the unexpected surge will prove ‘transitory’ – in other words, it’s not here to stay. The view that inflation will be short-lived is shared by three quarters of global fund managers, according to the latest Bank of America Merrill Lynch survey.
However, it would be prudent for investors to ensure their money is working hard, whatever happens. Here’s what you need to know for different parts of your finances:
Long-suffering savers have not seen much return on their money while interest rates have been at rock bottom. The average easy access account paying just 0.17%, according to Moneyfacts, which means in real terms savers are losing money with every day that passes.
You can get more by shopping around, but even the best-buy accounts pay a mere 0.5%.
Fixed-rate bonds also pay less than inflation with savers needing to leave their money locked up for five years just to get a return of 1.35%. While rates are so low, it’s still important to maintain the all-important rainy-day account for unexpected expenses, so just make sure you’re getting the highest rate you can find.
The main challenge to fixed income is the negative real returns from conventional government bonds at a time of rising inflation. Ten-year UK gilts are currently yielding around 0.8%. This is up from just 0.2% at the start of the year but this is still negative in real terms.
These are not the only types of bonds, however. There are different kinds available that pay higher returns, but you need to be prepared to take much higher levels of risk. A little more risk than gilts would be looking to investment grade corporate bonds, issued by companies that most investors will have heard of, such as Apple. The average yield on an investment grade corporate bond fund is currently around 2.6%.
Further up the risk scale are high yield bonds and emerging market bonds, which pay higher returns because of the greater risk to your money. High-yield bonds are issued by companies with lower credit ratings and the average yield on a high-yield bond fund is around 4.2%. Emerging market bonds are issued by companies or governments in developing countries. Brazilian ten-year sovereign bonds yielding almost 10% now.
Specialist inflation-linked bonds (also known as index-linked bonds) pay interest that rises with inflation. They aim to offer protection when stock markets fall, as well as shielding against inflation, so could prove very popular in the coming months.
It is important to consider the types of assets held in your ISA or pension, and how these might be impacted by rising inflation. If you favour shares you might want to look for companies with a concrete market position, with strong balance sheets that can get through economic cycles.
In terms of funds, consider those that contain a number of relatively inflation-proof holdings. Many experts advocate absolute return funds which aim to deliver positive returns even in tough market conditions. However, many fail to do so, which means careful fund selection is crucial. Absolute return funds also tend to come with high charges – so it’s important to keep an eye on what you’re paying.
An inflation-proofed investment portfolio might include gold and infrastructure investments as well as shares and bonds. The draw of infrastructure projects such as toll roads, hospitals and schools, is that they are on very long-term contracts and so provide a very steady income stream.
Gold is seen as an inflation hedge because the precious metal has traditionally been a reliable store of value. Yet for long-term investors, experts are convinced there is no need to make any dramatic changes as long as you have a balanced, diversified portfolio of quality assets.
Those lucky enough to be in final salary schemes will almost certainly receive inflation-linked payments. Pensioners that have bought an inflation-linked annuity will see an increase to their income. Yet the majority of annuities bought last year provide a fixed rate of income.
If you’re approaching retirement, it’s worth remembering that if a guaranteed income is important to you, it’s no longer a requirement that you use all your pension savings to buy an annuity. Instead, you can buy an inflation-linked annuity with enough of your pension pot to generate the minimum income you need, and leave the rest invested using drawdown. The idea is that growth in your investments should help hedge against inflation.