Bonds linked to inflation to prove popular

IRISH SAVERS are likely to start following a trend that has seen borrowers and savers in Britain and elsewhere turn to inflation-linked bonds as a key defence against the ravages of recession on their finances.

The British water utility, Severn Trent, last week raised £75 million (€94 million) from retail investors through the issue of such bonds.

The move followed similar issues by a number of other bodies, including Britain’s national grid, the company that operates its electricity network, which raised more than £280 million. Tesco Bank and the social housing group, Places for People, both raised smaller amounts.

Inflation-linked bonds tie the returns on the investment to consumer price indices.

Typically, they are issued by utilities, whose income tends to be closely tied to inflation, or sovereigns, whose returns on taxes such as VAT tend to be similarly pegged.

According to Shane O’Reilly of investment manager, Smith Williamson, a key feature is that they preserve capital.

Mr O’Reilly points out that inflation erodes the value of capital over time. Returns on a range of investments do not necessarily compensate for this.

Smith Williamson’s figures show that over the 10 years to the end of 2011, the average Irish pension fund returned 1.2 per cent a year, while inflation averaged 2.2 per cent over the same period.

Inflation-linked bonds also avoid the volatility associated with other investments.

The FTSE 100 has returned 143 per cent over the 25 years since 1987 but there were marked swings within this period.

Over the same period, UK government inflation-linked bonds returned 315 per cent. Within that, the bonds frequently lagged equities, but delivered steady returns.

Their renewed popularity is down to the fact that central banks in many developed countries have been printing money to combat the recession, which leads to inflation.

Mr O’Reilly agrees that recent falls in commodity and oil prices point to an easing of inflation. However, he says that central banks are likely to view this as giving them further headroom to print more money, which is likely to increase pressure in the medium term.

Last week’s European Central Bank rate cut, which left its basic rate at an historic low of 0.75 per cent, is also likely to boost the popularity of such bonds.

Smith Williamson, which has been operating in the Republic since April 2011, offers the bonds to its clients here.

The firm took part in the Severn Trent issue, which was a 10-year bond.

Mr O’Reilly says the company recommends that clients purchase the bonds only as part of a balanced portfolio.