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View on new M&G inflation-linked fund?

Investment | Fixed Interest Helpful? 12

Asked by Islaylassie, submitted 13 September 2010.

Open Quote The FT reports that M&G is about to issue an index-linked corporate bond fund:

To quote from the article,

'While inflation remains low, however, advisers do not see the fund as a buy. “Once we see CPI or RPI come down for a couple of months, the market will anticipate much lower inflation – then fixed rate bonds will do well and inflation- linked bonds will not do well,” says Sels.

Dennehy advises a “wait and see” approach as he does not expect inflation to be a risk in the next 12-24 months.'

What's your view on this fund?
End Quote

Answered by Justin on 14 September 2010

The M&G UK Inflation-Linked Corporate Bond fund is to be run by Jim Leaviss and Ben Lord, who have an indifferent track record of running fixed interest funds at M&G. But while I wouldn't jump through hoops of fire to invest with these specific managers, is now a good time to invest in index-linked corporate bonds generally?

The key when investing in index-linked gilts/bonds is to look at the break-even inflation rate, i.e. the average rate of inflation between now and maturity that would cause the index-linked bond’s return to be the same as a comparable conventional bond. This shows the average level of inflation expected by the market - reflected by the price of the bond.

If you expect inflation (RPI) to be higher than the break-even rate then index-linked gilts/bonds could be preferable to conventional and vice-versa.

Some break-even inflation rates (RPI) for several gilts at the time of writing (I'd expect rates for bonds to be similar):

2.5% 2016 I-L Gilt: 2.49% breakeven inflation.
2.5% 2024 I-L Gilt: 2.96% breakeven inflation.
2% 2035 I-L Gilt: 3.34% breakeven inflation.

So the market s already pricing in average inflation of 2.49% between now and 2016, a fall from the current RPI of 4.7%. If inflation does fall then what will really matter to index-linked investors is by how much and for how long.

I can see inflation falling next year (despite the VAT rise) and still believe there's a risk of deflation (i.e. negative inflation) if government spending cuts and tax rises bite as hard as I fear they will. So on this basis I'm not inclined to hold index-linked gilts and bonds.

However, some argue that inflation will soar off the back of a mini boom in a year or two's time, in which case index-linked investors will be sitting happy.

If you do want index-linked fixed interest exposure I'd opt for a low cost tracker (e.g. ETFs where annual charges are likely to be no more than 0.25%) rather than an actively managed fund. For an active gilt/investment grade manager to outperform they'll probably need to make successful predictions regarding interest rate and inflationary movements (and then invest in shorter or longer dated bonds accordingly to profit if they're right). Many managers either don't take such risks or get it wrong which, after charges, tends to mean underperformance versus a comparable index.

Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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