Bernard Abrahamsen explains how investors can best manage the ongoing market uncertainty and even use it to their advantage

With commodity prices having risen against a weak sterling backdrop, UK CPI at double the Bank of England's target rate, low cash interest rates and VAT price hikes feeding through, the pain of negative real interest rates could be set to continue. Couple this with the uncertainty surrounding interest rates, inflation and government policy, and you may ask if investors can hedge against the risk of high inflation in a senior, safe, secure and affordable manner.

Traditionally, we have looked to index-linked gilts for this purpose. For many years, active index-linked management did not offer sustainable outperformance over passively-managed funds as predicting market direction was notoriously hard and trading costs were very high. Consequently, outperformance often came in big lumps accompanied by corresponding high risk. Today though, supply and liquidity are both plentiful thanks to the UK government issuing a huge amount of debt and trading costs have fallen significantly. Volatility and inefficiency across the yield curve is substantial, and the effect that new issues have on the market is predictable. Diligent managers are able to exploit several opportunities and earning 1% p.a. over a benchmark is an entirely feasible target without taking on excessive risk.

Beyond index-linked gilts, the next logical investment opportunity to look at is index-linked corporate bonds. Unlike the index-linked government bond market, a relatively small number of corporate 'linkers' are issued, and they do not tend
to trade in the secondary market at all and are therefore relatively illiquid. Furthermore, few companies want to issue index-linked bonds right now, for fear that it could be an expensive choice. Corporate linkers nonetheless can be a suitable source of inflation protection as well as offering superior yields to index-linked gilts, but investors in the market are subject to all the risks that a lack of diversity can bring to a portfolio as, generally, only a few sectors issue index-linked corporate bonds, e.g. supermarkets and utilities.

An alternative to index-linked corporate bonds lies in purchasing a property outright. For example, instead of buying a supermarket operator's bond, buy the supermarket itself and rent it back to the operator. If you can agree a long-term lease and rental payments that increase with inflation, what you have is something that resembles an index-linked corporate bond in terms of its cash flows. The difference is that it is also secured against an underlying property, so the opportunity for capital gains exists. Furthermore, should your tenant default, you have the chance to re-let the property to one of their competitors. The returns on a long lease such as this can be far superior to comparable bond investments.

Another potential source of inflation-linked cash flows lies in lending to not-for-profit Housing Associations (HAS), who provide all the social housing in the UK. Properties are offered at below-market rents which rise, in general, by a little more than inflation, allowing investors to meet their inflation-linked liabilities. The HAS will typically pay back the capital of the loan through its term, unlike a bond investment, thereby reducing the risk that the lender will not see their capital returned to them.

Whether as an investor, you choose actively managing index-linked gilts, lending to companies on an inflation-linked basis, lending to HAS, buying leases or any other form of inflation protection, we believe that you should plan for ongoing uncertainty. We expect higher volatility in 2011 than we saw in 2010. The macroeconomic drivers of bond markets remain unpredictable. For us, this year's letter is the letter 'S' – Simplicity, Safety, Seniority and Security. Riskier investments and asset classes may be tempting, but are they necessary given the returns available in safer ones? Perhaps we should all be content with outperforming inflation and save ourselves some sleepless nights.

Bernard Abrahamsen is head of sales and distribution at M&G Investments

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