Consumers are seeing energy price hikes feeding through into higher household heating bills and, we expect the UK’s energy price cap to rise further in October from Ofgem’s +54% April price cap increase. Ofgem’s April reaction reflects the significant rise in wholesale gas and electricity prices as demand has recovered as the pandemic has eased, whilst the supply recovery has been weaker.

However, that is but part of the cost of living squeeze. Firms are facing higher costs of production from a wider array of factors such as: costs for raw material, energy, labour and freight and logistics.  Productivity gains can and do absorb some proportion of these inflationary forces but, the stark reality is that consumers are going to indirectly absorb the remainder through higher prices of goods and services.

The UK’s Consumer Price Index (CPI) rose to 9% in April, its highest level in forty years and Chancellor, Rishi Sunak, warned the electorate of ‘tough months ahead’ as the somewhat transitory inflation narrative appears to be becoming a little stickier  across Western economies.  

Over the past few decades, we as investors have grown more accustomed to looking at investments in nominal terms i.e. without taking explicit account of inflation. This has been somewhat accepted with the implicit knowledge of relatively low levels of inflation. But, if inflation becomes a structurally higher phenomenon, we may have to shift our thinking towards real returns i.e. nominal returns less inflation.

To protect against inflation, investors should seek out investments that have real return potential. After years of low interest rates and quantitative easing the outlook for nominal government bonds looks challenged: today’s UK 1Y Gilt yields 1.4% if held to maturity but, the current 1Y forward inflation expectation is 6%. So the real return on that bond would be -4.6% if inflation expectations prove accurate; better than cash returning -6% but less than ideal.

To protect against inflation, investors should seek out investments that have real return potential.

As a predominant equity investor I thought I should educate myself more on the workings of inflation-linked bonds to assess their inflation protection potential. Like all bonds, inflation-linked bonds have a principal value. This is the amount of money the issuer agrees to pay the lender at bond maturity i.e. the borrowed amount. For a government bond this is a nominal amount say £100 (regardless of what inflation occurs). However, for inflation-linked bonds it’s a real £100 because an inflation-linked bond’s principal value at maturity is adjusted upward in nominal terms to account for the inflation that occurs through the bond’s life. Inflation-linked bond coupons are paid semi-annually and also offer a real return as the nominal coupon payment rises with inflation.

Mechanically I’ll receive a real return for holding inflation-linked bonds and overcome inflation. Except here comes a nasty catch; unless I hold the bonds to maturity I’m exposed to price fluctuations just like other assets. In fact, I’m exposed to real interest rate changes which reflect changes in nominal interest rates and inflation expectations. So, I need to think carefully about my inflation-linked bond’s price sensitivity to real interest rates – that’s real duration risk!

Managing your wealth

Managing your wealth

Understanding Finance

Helping clients understand what we do is key to building relationships. To explain some of the industry jargon that creeps into our world, we’ve pulled together a section of our site to help.

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