Between 1985 and 2010, the RPI increased at an average rate of 3.4%. So in 2011 we have inflation above the average.
With traditional inflation-proofing investments delivering below-inflation returns, this creates a dilemma for investors who are looking for growth but are unwilling to take greater risks with their capital.
Index-linked National Savings Certificates have been stalwarts in the fight against inflation in the past, but were withdrawn from the market in July 2010 and only relaunched in May. Not surprisingly, demand was very high, but for a five-year term paying just 0.5 per cent above the RPI with a maximum investment per person capped at £15,000, terms are not as good as previous issues.
Corporate bonds have been another means of generating yields above inflation, although one-year performance figures show many are barely scraping above inflation. High-yield bonds and emerging market bonds are better performers, but these come with higher risks attached. And, of course, yields fluctuate so there is no guarantee they will beat inflation over five years.
Commercial property has been another mainstay investment in the past, but property prices and rental yields, perhaps with the exception of London, have been flat or falling in 2011.
Gold has risen massively in recent years – it is now over £1000 an ounce – and if global economic uncertainty continues it could rise further. However, the market seems to have many people believing we are in a “gold bubble” and the commodity is near or above its peak price.
Finally, the stock market has been volatile in 2011, dogged by a steady and, it seems, ongoing flow of bad economic news coming from the US, China, Europe and elsewhere, creating uncertainty over the global economy that looks set to be with us for some time.
Well, almost finally, one strategy that is often overlooked as a means of potentially achieving inflation- beating returns is the use of structured investments. These contracts usually last five or six years and offer a set rate of return if a stock market, such as the FTSE 100, is at or above the level it started at in year one. An investor buying a structured investment that offers a defined return of, say, 60% after six years if the FTSE is above where it is now, gives the investor a good potential margin on inflation.
Should the underlying stock market fall, then most structured investments will protect capital either at 100% or until the stock market drops more than 50%, preserving original capital to that point. While receiving capital back intact does not protect the investor against inflation over the six years, many structured investments have the potential to provide better returns than direct equity investments when stock markets do badly.
In addition, structured investments looking to achieve growth will normally attract capital gains tax (CGT) and, since the maturity date of each investment is already known, using structured investments and careful financial planning can make the most of an individual’s CGT allowance each year.
Volatile markets can often allow these contracts to be favourably priced. The downside to the investments is that the rate of return is fixed (this is the cost of the protection element), so if the stock market has risen strongly in six years then the investor will not achieve the additional returns above their pre-determined fixed level. However, an investor may decide that this is a price worth paying, as there is no guarantee where stock markets will be and under the terms of many structured products, even a 1% increase in the stock market between day one and the end of the term will see them receive their defined return of, say, 60%.
The flexible nature of structured investments means they can be designed to meet specific demands. The market has already responded to the dilemma investors are experiencing around inflation.
For example, in January, as UK inflation continued to rise towards the 5% mark, Jubilee Financial Products released its Inflation Linked Income Plan, giving the previous year’s increase in the RPI year on year plus 2%. And with the RPI still at 5%, Morgan Stanley has recently launched an inflation focused product that gives a fixed income payment of 5.25% in year one, then four annual gross income payments of 1.5 times any year on year increase in the RPI (July to July), with the return of original capital in full unless the FTSE 100 has fallen more than 50% from the initial index level.
It should be noted here that the capital investment and the contract to deliver the returns is held with a counterparty, usually a bank, and if that bank fails or is otherwise unable to meet its contractual obligations, investors could lose their investments. This is where careful selection of the counterparty is necessary, to help mitigate this risk.
Of course, structured investments should not be used in isolation to combat inflation. However, blended in a well-diversified portfolio, they can allow the investor to benefit from the best of both worlds … an inflation- beating upside when markets rise, as well as defined downside protection, mitigating losses when they fall.
:: Ian Lowes is managing director of Lowes Financial Management, based in Jesmond, Newcastle.
This article originally appeared in the Newcastle Journal & Evening Register.