With inflation-linked bonds, should inflation turn out to be 1 per cent annualised for the next six years, your return would be 1 per cent annualised. Should inflation turn out to be 4 per cent annualised over the next six years, your return would be 4 per cent annualised.
The certainty of outcome before the effect of inflation is incredibly valuable at a time when the path of inflation is so uncertain.
The effects of inflation on a fixed stream of cash flows can be quite severe, especially when inflation shocks persist for multiple years. Much like comparing a US equity fund to the S&P 500, one can compare a nominal bond return with inflation.
If a US equity fund returned 10 per cent in a given year you might think that this was a great outcome but if the S&P 500 had returned 12 per cent you would be focused on the negative 2 per cent performance relative to S&P benchmark.
Similarly, if a nominal bond has a yield to maturity of 3 per cent but inflation is running at 5 per cent, you would focus on the negative 2 per cent ‘real return’.
Why is this important and why should investors even think about inflation when central bankers initially told us that it was transitory?
It is worth remembering that the impact of inflation can be hugely corrosive over time, even at relatively low levels. This is basic mathematics, but unfortunately for investors the outcomes can be severe if they are not understood fully.
For example, at an inflation rate of 3 per cent, it would take just 15 years to erode the purchasing power of a pound by a third. This is why we think it is important for investors to consider the impact of inflation on their portfolios or at least think about how they can mitigate it in an environment where inflation is no longer at very low levels.
How to measure inflation
Inflation is measured in slightly different ways depending on the country and the methodology used, but ultimately it is trying to assess the average price changes within an economy.
For example, in the US, the owner's equivalent rent of residences – the hypothetical amount a homeowner could get for their house if they rented it out – has a weighting of around 24 per cent in the US CPI.
In the Eurozone, the actual rentals for housing currently has a weighting of around 7 per cent. In the UK, the equivalent rental weight is around 8 per cent but there is also an additional series for house price depreciation, which takes the total weighting to around 10 per cent.
