How to guard against inflation when investing in bonds

UK Index-Linked Gilts has been the best performing IMA sector so far this year (Source: Getty)
Periods volatility in equity markets typically see investors flee to the apparent safety of fixed income – especially the bonds of major Western governments, the yields on which are often described as the “risk-free” rate. But as Christopher Maule of the UK Bond Network argues, it’s a strange definition of “risk-free” that sees investors exposed to the danger of sub-par or negative returns once inflation is taken into account.

Consumer price inflation is admittedly low at the moment, but it’s likely to pick up in the coming months and years. So what alternatives are there for fixed income investors who want to protect themselves?

According to Laith Khalaf of Hargreaves Lansdown, one option is to look at inflation or index-linked products. “It’s a difficult one, because fixed income is always vulnerable to rises in inflation, but inflation-linked bonds could help minimise the effects.” These bonds differ from most fixed income products in that the returns are adjusted in line with inflation.

And according to data provided this week by Hargreaves Lansdown, UK Index-Linked Gilts has been the best performing IMA sector so far this year, growing by 11.7 per cent year-to-date, compared to 8.8 per cent for the UK Gilt sector.

Beyond government-issued products, Khalaf highlights inflation-linked corporate bond funds as another option. The M&G UK Inflation Linked Corporate Bond Fund is a popular choice, he says. It’s returned almost 12 per cent on a total return basis over a three-year period.

But buying into the higher-yield sector – whether that’s through emerging market debt or riskier corporate bonds – could be dangerous. True, the returns could be higher: “emerging market bonds have outperformed Treasuries with returns of 21.4 per cent versus 16.1 per cent over the last four years,” wrote Russ Koesterich of BlackRock in a recent blog post for the website Market Realist.

But Khalaf points out that the high-yield sector is obviously far more prone to the risk of defaults, and won’t necessarily serve the same purpose in investors’ portfolios as government bonds.

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