Investing in an inflationary environment

Inflation fears have prompted the Bank of England to edge closer to raising interest rates, as the latest minutes of the bank’s Monetary Policy Committee has shown, three of the nine-member committee voted for a rate hike in February.

This more hawkish tone is being taken because the UK's inflation numbers continue to be above the bank's upper limit of 3% and around double the target level of 2%. The Consumer Prices Index (CPI) jumped to 4.4% in February

However, Bank of England Governor Mervyn King is unlikely to raise rates just yet to bring down inflation because to do so would risk damaging the fledgling economic recovery. As has been seen in recent reports, growth in the UK softened at the end of 2010.

Mr King expects that prices will fall back because the current high level of inflation is largely due to one-off factors such as the recent VAT rise and high oil prices. And the Bank's forecast is that inflation will peak at between 4% and 5% this year, before falling back to the 2% target later in 2012.

The M&G Retail Fixed Interest team agrees with Mr King that inflation is likely to fall back in the long term. The developed world generally faces disinflationary factors due to the spare capacity in the economy and the fact that unemployment is high in the West, will help prevent a wage-inflation spiral.

Until such time as inflation eases, investors need to protect themselves from having their wealth eroded by rising prices for goods in the short term (petrol reached a record high of £1.30 a litre in March and alcohol shot up 6.7% between December 2010 and January 2011, for example).

Additionally, nobody knows quite what the results of quantitative easing will be. History has shown that whenever governments print massive amounts of money, the result has always been an increase in inflation - and sometimes a very sharp increase.

The Bank of England also acknowledges that it has become more difficult to predict the future level of inflation with certainty, and that it is more likely that inflation will over or undershoot the target level.

To protect an investor's money from inflation, inflation-linked bonds provide one of the best hedges. With inflation-linked bonds the investor's capital and income are both uplifted by inflation. This means that, provided the issuing government or company does not default on its bonds, the long-term investor should be fully protected from inflation.

For this reason, M&G launched the M&G UK Inflation Linked Corporate Bond Fund in September 2010 to have an investment proposition ready for investors in case inflation takes off. We remain positive on the outlook for credit (in other words, corporate bonds are still cheap) this new fund combines exposure to corporate bonds with the aim of inflation-proofing that comes with index-linked gilts. This should over time enable investors to get a better total return than simply buying index-linked gilts. Over the medium to long term, the M&G UK Inflation Linked Corporate Bond Fund aims to deliver a return that matches or exceeds CPI.

The M&G Retail Fixed Interest team still holds a very positive view on credit, believing that companies are generally in better financial health than many developed-world governments. This is because they have already had to undergo their own round of ‘austerity' measures, such as cost-cutting and de-leveraging, whereas governments have tended to expand their balance sheets to prop up economic growth.

Also, the outlook for defaults has improved vastly over the past couple of years, which is good news for bond investors as they can then be more certain of receiving income from their bond holdings.

And yet credit spreads (the level of yield above government bonds of similar maturity) are still relatively generous. As a result, we feel that many corporate bonds are still rewarding investors well for the risk of default.

For more views and commentary from the M&G Retail Fixed Interest team, please visit the team's blog at www.bondvigilantes.co.uk.

For Financial Advisers only. Not for onward distribution. No other persons should rely on the information contained in this article. This Financial Promotion is issued by M&G Securities Limited which is authorised and regulated by the Financial Services Authority and provides investment products. The company's registered office is Laurence Pountney Hill, London EC4R 0HH. Registered in England No. 90776.