From time to time, Morningstar publishes articles from third-party contributors under out "Perspectives" banner. Below, Nick Beecroft, chairman and senior market analyst at Saxo Modern Wealth Management, which is sponsoring Morningstar's Seeking Income Week, outlines the investor toolkit for tackling inflation.
With interest rate returns on deposit accounts close to zero, lingering fears with regard to the safety of banks and building societies (the sight of those queues outside branches of Northern Rock are emblazoned on our psyche now), and the seemingly endless eurozone debt crisis with its concomitant threat of financial Armageddon, investors are searching for ‘safe’ yield like never before.
The answer for many has come in the form of the so-called safe-haven government bonds of the US, Germany, UK and even Denmark, Finland and Sweden. As a result, towards the end of Q2 2012, the creditor countries of the eurozone (e.g. the Nordic countries, but especially Germany) exhibited rapidly falling bond yields. German 30-year yields reached a low point of 1.629% and Danish equivalent bond yields dropped to 1.486%. Although investors in such bonds can presumably be very confident that their money will be returned in one piece, the real return on their investment, i.e. after deduction of inflation, is pretty terrible. German inflation has been relatively stable at 1.5% during the past 15 years.
For Danish long-term bonds, the situation is even more dire. With inflation averaging 2.2% over the past 15 years and yields even lower (10-year yields at 1.34%), investors are locking in a fat negative real yield by holding Danish bonds.
So what are the other options? Nothing in life is free; the yields on safe government bonds are miniscule for a reason—because they are so safe! To gain extra yield an investor will inevitably have to take incremental risk, whether by buying the government bonds of a less highly rated country in the emerging markets, say, or the bonds or stocks of public companies. The key to a prudent search for the best possible real yield is to find a sensible array of investments which create a diversified portfolio, balancing risk with return.
Let’s consider emerging market bonds first. In addition to possibly elevated credit risk, a direct investment in such a bond will expose the investor to the risk that the currency of denomination of the security depreciates over time against sterling, hence diminishing the sterling value of the principal invested, so this type of investment is definitely not for the faint hearted or unsophisticated investor. It is however possible to find bond funds which promise to hedge this currency risk.
The answer lies closer to home for most investors, in the shape of corporate bond funds, equity income funds comprised of these enterprises, or the dividends from the individual shares of blue-chip companies. The utility companies are a particular favourite in the latter space—especially electricity and water providers. One can be reasonably confident that these companies have firm foundations and will enjoy solid sales for the foreseeable future—after all, their success is not dependent on the creation of a ‘better mousetrap’ in any sense.
One final asset class to consider if you’re concerned about the erosion of the value of your investments by inflation is UK Government Index-Linked bonds. In a sense, this ship has already set sail; ever since the Bank of England started printing money ‘index-linkers’, as they’re known, have enjoyed a tremendous following, driving their price up such that the yield on same is now actually negative. At least you can sleep at night, confident in the knowledge that the real value of your principal will be protected, as the amount returned to you if you hold the bond to maturity is linked to how prices have risen over the lifetime of the bond. The degree of protection will of course depend on the price of the bond when you acquire it.
Additional Information
The views contained herein are those of the author(s) and not necessarily of Morningstar. Saxo Modern Wealth Manager is sponsor of Morningstar’s Seeking Income Week. The instruments mentioned in this article can be invested in directly or via Funds or ETFs—all available at Saxo Modern Wealth Management.
