M&G UK Inflation-Linked Corporate Bond - research update

Richard Troue | Tue 20 September 2016

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The latest figures from the Office for National Statistics show consumer price inflation remained at 0.6% in August. This confounded economists who expected inflation to rise, in part because the value of the pound has fallen sharply against other major currencies in recent months. A weaker pound makes goods imported from overseas more expensive, which increases costs for manufacturers and retailers, and in turn prices at the till often rise.

In reality, the influence of currency depreciation or falling commodity prices takes time to feed through fully into the inflation figures. This is because its takes a few months for existing inventories and stock to run down and some companies, such as supermarkets, take steps to protect themselves against short-term currency movements – this is often referred to as ‘currency hedging’.

Ultimately, these factors will fall out of the equation and companies will have to choose whether to pass input costs – which rose 7.6% in the year to August 2016 – on to consumers. Forecasts suggest the drop in sterling will ultimately add around five percentage points to the Consumer Prices Index, but it’s unclear whether that will come via a gradual uptick in inflation over a couple of years, or a shorter, sharper bout of inflation over the coming months. The Bank of England forecasts consumer price inflation will hit 2% this time next year.

Should investors be worried?

As inflation climbs every pound you hold buys less and less, and over the long term even modest inflation can significantly erode the value of the pound in your pocket. Broadly speaking £10,000 of goods in 1995 cost over £17,000 by 2015, for example.

Some investments have the specific aim to offer a return in excess of inflation over the medium to long term. One of our favourites is the M&G UK Inflation-Linked Corporate Bond Fund, managed by Ben Lord and Jim Leaviss.

The managers invest partly in a portfolio of short-dated, index-linked government and corporate bonds. In addition, the managers use derivatives to add an element of corporate bond exposure alongside the index-linked government bonds, giving the portfolio exposure to corporate bonds with some inflation protection. Companies are seen as more likely to default on their debt than the UK or US government, so investors demand a greater return for the additional risk involved. This additional flexibility gives the managers greater scope to achieve an inflation-beating return. Derivatives are also used to reduce the sensitivity of the fund to rising inflation or interest rates, although this does add risk.

Presently, around 25% of the fund is invested in US index-linked government bonds (Treasury inflation-protected securities, or Tips) as Ben Lord and Jim Leaviss note they offer more attractive yields than their UK equivalent. They also have inflation-linked exposure to a number of US companies, including Microsoft, Verizon and AT&T, although exposure to the US dollar is hedged back to sterling.

Closer to home the managers have invested in bonds issued by UK utility and financial companies, including National Grid, Anglian Water, Nationwide and Aviva. The corporate bond investments are focused on higher-yielding investment grade bonds and higher-risk, high-yield bonds, where the managers feel they can find attractive yields for the risks taken. A proportion of the fund could also be invested in bonds issued or guaranteed by an EEA state.

Our view

Recent sterling weakness certainly increases the potential for inflation to rise. In addition, the Bank of England continues to use every tool at its disposal to stimulate demand and inflation, including more QE and cuts to interest rates.

Inflation shocks are inherently difficult to predict. This fund is managed by an experienced team, which we hold in high regard. We believe it could offer some shelter against short-term inflation shocks and the potential for inflation-beating returns over the medium to long term. Since launch in September 2010 the aim to achieve an inflation-beating return has been achieved, although the past is no guide to the future.

Past performance is not a guide to the future.

Source: Lipper IM to 01/09/2016

It is invested differently to most conventional bond funds. The capacity to perform well if inflation or interest rates rise means it could offer diversification to a bond fund portfolio and the potential to perform well when other bond funds struggle, although this is not guaranteed. The fund retains its position on the Wealth 150 list of our favourite funds across the major sectors.

Find out more about this fund including how to invest

Please read the key features/key investor information document in addition to the information above.