How to protect against inflation

Paul Burgin discovers the benefits of inflation-linked structured products.

Recent jumps in inflation have spooked investors but a handful of structured providers are developing straight inflation play products in response.

The Retail Price Index hit 5.1% in January, increasing from 4.8% on the previous month due to fuel, gas and food price hikes, according to the Office for National Statistics. Now markets fear China, the rest of Asia and Latin America will have to raise interest rates to combat escalating consumer and factory input prices.

Nervous reaction

In reaction, nervous investors are asking their advisers and discretionary managers for ways to inflation proof their investments. The retail structured product and bond market has responded with a series of inflation-linked products that use the Retail Price Index to calculate payoffs.

RBS is one example. In November it launched an inflation-linked bond paying a minimum 3.9% or RPI, whichever is higher. Income is paid quarterly and the bond has so far attracted inflows of around £50m.

Multiplier products

RBS also offers an inflation multiplier product that pays 1.3 times RPI, based on a two month look back. If UK inflation falls or remains flat, no coupon is paid for that period. The product has proved less popular with investors than the 3.9% floor bond, only attracting around £15m since launch.

Ben Board, director at RBS listed products, says the multiplier product has just made its first quarterly coupon payment, equivalent to an annual rate of 4.77%. He adds: “If inflation continues to rise the multiplier should do well.”

Both bond products have seen price falls on the secondary market as senior bank debt has been marked down. Board admits that can be uncomfortable for existing bond holders but says the floor plan has a current gross redemption yield of 6.2% as a result.

By definition, inflation-based returns are backward looking. Investors may experience faster rising prices, or need income rising faster to match their expenditure, than these products can provide. The solution for inflation-backed structured product providers is to add in an equity or other index link that puts capital at risk.

The Jubilee Inflation Linked Income Plan does exactly that to boost returns. It offers the previous year’s increase in the RPI plus 2% gross income per annum. It pays out a monthly equivalent over the six year life of the plan. Should inflation drop below zero, investors get a minimum 2%.

The capital return depends on the performance of the FTSE 100 Index. Should the index fall below 50% during the term and fail to recover to its initial level, capital will be reduced 1:1 against the shortfall at maturity. The counterparty is UBS.

Income contracts

Ian Lowes of Lowes Financial says the Jubilee product is the only one of the current crop of inflation products he thinks is worth recommending. He says: “It is an income contract that just happens to be related to RPI. When it strikes the first year income will be one of the best on the market.”

Lowes says the product will be paying out almost 7% at a time when other straight income products are paying 5.75% per annum. He also says that should inflation fall throughout the investment period, investors will see their income drop – which may not be the case with other products. He says: “Falling inflation does not mean falling prices, it just means they are going up more slowly.”