Investment

The investment clinic

In his latest case of a financial and investment problem faced by an independent school, Chris Hills reviews the likelihood of a solid income from Government bonds in the light of a possible rise in interest rates

Q: Our investment portfolio is heavily skewed towards Government bonds to provide an income for bursaries. One of our governors has questioned this policy in the light of higher rates of inflation and what might happen if interest rates rise. Is this something we should worry about?

A: The level of inflation has been stubbornly above the Bank of England’s 2 per cent target and in 2010 the annual rise in the Retail Price Index was 4.8 per cent. Indeed, the level has exceeded the target in all bar eleven months since the end of 2002. There is growing concern that the inflation genie may have made its way out of the bottle and that measures to contain it may cause greater damage to the economy as a result.

Investment portfolio or not, rising prices can be expensive on many levels. Were inflation to average 5 per cent per annum in the future, the real purchasing power of your money would halve within 14 years. While this might please those in debt, keen to see the real value of their liability fall, it would clearly reduce the ability of many schools to service their needs, whether for bursaries, staff wages or building maintenance.

In a fix
While the holding of bonds will tend to give you an income stream, the problem is that the payments from each holding do not rise with prices: they are, literally, “fixed interest” stocks. The return from bonds is a steady, predetermined stream of coupons and a final redemption payment. In addition, these returns are also known, providing (in the case of gilts) the Government does not default on its obligations.

The problem is that, for conventional bonds, the payments can be eroded by rising prices so that each pound of return is worth less in real terms when the effects of inflation have been factored in. In addition, if any bonds are not held until the redemption date, their capital values may fall as a result of the higher inflation (and/or any higher resulting interest rates). Higher inflation and higher interest rates will make other instruments more attractive than a low-yielding Government stock.

The long haul
Schools should ensure, for long-term investments, that at least part of their funds is held in assets that can provide a rising income over the long-term, hopefully at least in line with rises in prices. These are often classed as “real” assets and include investments such as equities and property. Ultimately, these assets are linked to the growth in the economy rather than rises in nominal prices. Real assets work because, as inflation rises:
• UK companies can raise their prices and so protect their profits;
• landlords can push up their rents; and
• with assets such as index-linked gilts and infrastructure projects, the income payments can be linked to an inflation index.

The dichotomy is, however, that some of the real asset classes can be both lower yielding and more volatile. As ever, the skill is in balancing a portfolio to give sufficient income and insurance against economic troubles, coupled with adequate investment in real assets to seek protection against inflation.

Mixing it up
It may be that, over time, withdrawals from your portfolio can be made from a mixture of income and capital growth. This would enable you to move further into real, lower yielding assets.

You should note, however, that capital gains are less likely to be regular and steady, and there may be times when you will need to take funds from a portfolio that has fallen. Such facts of life will mean that you should be careful not to spend too much of any capital gains in the higher return years.

Depending on the level of income you are drawing from your portfolio, this could be a problem for you. You may not be able to restructure towards lower yielding real assets if you are fully reliant on the income provided by your bonds today. Ultimately, however, today’s income is unlikely to be sustainable using this policy in the long-term.

This presupposes that inflation is here to stay. The remit of the Monetary Policy Committee is to look at what it thinks will happen over a 24-month period and, while it expects inflation to stay high for the next 12 months, it thinks it should fall thereafter. The problem is that input costs are still rising and inflation can become ingrained in the system, with workers wanting to see their wages rise in line with prices.

While inflation is driven by external factors, such as rising oil and food prices, this does limit the tools at the Bank of England’s disposal. In the current environment, it feels prudent to ensure that you are protected from stubbornly high levels of inflation.

Chris Hills is chief investment officer for Rensburg Sheppards. For more information or to send a query to the FIS investment clinic, contact Simon Barker on 020 7597 1250 or send an email to Simon.Barker@rsim.co.uk. 

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