I was going to take a week off writing about inflation – honestly I was.

But no sooner has everyone started fearing inflation, then financial providers have rushed out a slew of inflation linked bonds to shift for fat profits calm their nerves.

Only the other week in my piece on 10 ways to stop inflation, I pointed to the new Birmingham Midshires bond and made this prediction:

Banks and building societies are starting to offer savings products tied to the inflation rate. It’s clever thinking on their part, as the demand is likely to be huge.

I think we’ll see more of these in the next few months […] so keep your eyes peeled if you’ve got cash that you want to safely tuck away for years.

Did I say a few months? I meant a few days.

No really!

Your Inflation Linked Bond is in the post

Okay, even I was surprised to see the Post Office getting straight in on the act with its own inflation bond.

The Post Office inflation linked bond runs for a fixed term from 26 May 2011 to 27 May 2016 – assuming that our robot servants haven’t risen up and taken over our places by then.

Indeed, those five years will feel even longer, given that interest is only paid at maturity.

But here’s the good bit: The bond pays out an interest rate equal to the RPI rate of inflation in April each year, plus 1.5% a year – even if inflation is negative that year.

In other words, you’re guaranteed a real return of 1.5% a year.

With RPI inflation running at 5.1% as I type and the very best cash ISA savings account offering just 3.2% (and most under 3%) it seems an excellent deal.

You can put up to £1,000,000 in, too, so even high rollers among the Monevator faithful won’t have to lose out.

Snags include the fact that no withdrawals are allowed1, that it can’t be held in an ISA as far as I can tell, and that the bond could be yanked at any moment if over-subscribed.

More inflation linked bonds… from Credit Suisse!?

You needn’t go to The Post Office if you want inflation protection. The Yorkshire Building Society has also just launched a very similar five-year inflation linked bond that talks about RPI plus 1.5%. And this one can be held in an ISA.

On the face of it, that’s very attractive. So attractive, the Chelsea Building Society has launched the same product!

However, there are important wrinkles.

Firstly, both these bonds only pay 1.5% above RPI inflation once, on maturity after the five years is up, as opposed to every year like the Post Office account.

This is such a staggering difference I’ve re-read it several times to make sure I’m not missing something. As far as I can tell it makes the Post Office account, which pays the 1.5% annually, far superior.

Secondly, if you read the small print, you’ll find both the Yorkshire and the Barnsley bonds are actually being offered in conjunction with investment bank Credit Suisse, whom they term the ‘Account Manager’.

And consumer watchdog Which? has already raised concerns about how these Credit Suisse products (which they’re calling Protected Capital Accounts) are actually structured products.

Now, just because I prefer simple investments, that doesn’t mean that these bonds are automatically unsafe. As the prospectus for the Chelsea offer states:

Your money is protected in the same way as it is with any other bank or building society account you have. The Deposit Taker is therefore obliged to repay your original investment in full at maturity. Should the Deposit Taker default, there is no protection or guarantee provided by CSi or any other third party and you could lose some or all of your investment.

The Deposit Taker is a participant of the Financial Services Compensation Scheme which provides limited protection to deposit holders.

So theoretically you should at worst be able to appeal for up to the £85,000 compensation limit from the FSCS.

But the Credit Suisse products are still more convoluted than the Post Office account, which is a deposit account with the Bank of Ireland. (If that worries you, read this Which? account of how you’re covered).

Also note that both building societies are also offering another Credit Suisse product that offers 0.1% a year annually plus RPI inflation.

Presumably Credit Suisse had done the paperwork before the Post Office inflation linked bond with its annual 1.5% hit the shelves? I see no advantage, except again that the Credit Suisse product can be held in an ISA.

Will such bonds beat savings, anyway?

Comparing the minutia of these inflation linked bonds – and the many more likely to follow – is one thing, but there’s a big picture angle, too.

And that is that locking away your money for even 1.5% a year is a bit of a gamble.

It might seem a swell idea with RPI inflation running at 5.1% to get 1.5% on top for a return of 6.6% a year, but it’d be a stretch to bank on this situation lasting.

Essentially, you’re partly betting against the Bank of England’s credibility, given that it has officially targeted an inflation rate of 2% a year (albeit by the CPI measure, which is generally a little lower).

In a couple of years inflation might well be back around 2%, yet banks fighting for your deposits could be offering 6-7% in cash ISAs like a few years back. That would be a much better rate of return, and you’d be more likely to get it considering you could keep your money moving to chase the best rates – not the case if you lock it away for five-years in one of these inflation linked bonds.

Indeed, the Credit Suisse literature gives 30% growth in RPI inflation over five years as its example outcome.

Yet as Which? points out the last time this occurred was 1993!

Over the past 25 years, the average five-year return of the RPI index has been a far less exciting 16.1%.

Deflated expectations

With National Savings inflation linked certificates still withdrawn, it’d be churlish not to concede that the Post Office bond at least is worth considering, although that you can’t put it into an ISA is a real drawback.

Inflation proofing a chunk of what’s yours in lovely cash can’t be faulted.

Just don’t go overboard. For all the promotion of inflation linked bonds we’ll see over the next few months, the banks will simply be making hay from inflation worries while they can.

With the aftereffects of the credit crisis still rippling through the system, most still desperately need our cash. But I suspect they see no more chance of high inflation for years to come than does Bank of England governor Mervyn King.

1. Except in exceptional circumstances, and even then it will cost you. [↩]

Stop the press! Vanguard index funds are soon to be available for a monthly dealing fee of £1.50 thanks to a chunky price drop by Alliance Trust.

Previously Alliance Trust charged £5 per regular trade. It still charges £12.50 for a single trade.

The £1.50 rate only applies to new cash that you inject via an online direct debit. The minimum contribution is £50 and once you set up the monthly trade, you must pay in for at least two consecutive months.

The website implies this service is currently available, although I’ve been told by Alliance Trust that the launch has been delayed until Friday.

Regardless, this move is great news for passive investors because Vanguard funds are generally the cheapest trackers you can buy in the UK.

Now they are far more accessible to UK investors who make moderate monthly contributions. The cost of the £1.50 fee to your investment can be reduced down to a manageable 0.5% if you can drip-feed in £300 per month.

I personally try to ensure dealing fees never slice more than 0.5% off my investment, and the more you can dilute the impact the better, as flat-rate fees play havoc with small contributions.

Not fair

Vanguard trackers are not as widely available to DIY investors as other UK index funds, because most investment platforms don’t like the fact that Vanguard won’t pay them commission fees.

The limited competition makes getting a good deal difficult for small investors, so it’s worth knowing a few of the tricks of the trade.

The only way to buy Vanguard in the UK without paying dealing fees is to go through the Fair Investment Company.

Unfortunately the fairness doesn’t last long, as it levies an eye-watering 0.85% annual management charge – an unacceptable amount to any DIY investor, large or small.

Vanguard expands

Meanwhile, with inflation causing petrol pump prices to spin like cherries on a fruit machine, Vanguard has introduced two very topical new UK funds:

• UK Inflation Linked Gilt Index fund, TER 0.15%, initial charge 0.4%

• UK Long Duration Gilt Index fund, TER 0.15%, initial charge 0.15%

The first fund offers a measure of inflation-protection for the fixed income part of your portfolio by investing in UK index-linked gilts that pay out a higher coupon in the face of rising prices. Many passive investors hold 50% of their bond allocation as index-linkers, and Vanguard’s fund comes in cheaper than its rivals, if you’re prepared to buy and hold for several years.

The second fund offers exposure to UK government bonds with maturities of greater than 15 years. Longer-dated gilts are riskier than their short-dated counterparts as they’re more vulnerable to unexpected rises in inflation and interest rates. However, they are a good diversifier in the face of a stock market crash. In this scenario, money flees equity and seeks a safe haven in high-quality bonds with longer durations.

The Vanguard Long Duration Gilt fund is the first tracker to focus on this part of the gilt spectrum in the UK, and is another heartening improvement in the lot of British passive investors.

Useful information on these funds is still very scarce. You can tell that by a quick glance at the factsheets, which are really more sheets at this stage. As ever with new funds, it’s a good idea to give them a while to settle down before wading in.

Take it steady,

The Accumulator

Some things worth reading this weekend.

A friend of mine sent me a copy of Collateral Damage: Global Crash Phase Two, from new publisher Moving Toyshop Books.

A little knowledge is a dangerous thing. I can see why she’d think this collection of writings from market insiders, pundits, and economists would be up my street. And the truth is I will tuck it away and finish reading it in ten year’s time when I fancy a bit of apocalyptic nostalgia.

But as regular Monevator readers will know, little winds me up more than after-the-event experts who even worse bang the drum for a dance that’s already out of fashion.

I wonder how many of the authors of these largely two-year old essays were worried about the instabilities inherent in the financial system before the CDS hit the fan?

I was, albeit relatively naively. Unfortunately I only started Monevator in 2007, but you can get a flavor of my bearishness from this pre-crash post on the UK buy-to-let boom.

What we can know, though, is that these authors thought the world was ending in 2008/09, as did the book’s editor. In fact, he writes in his introduction:

If there is a consensus in Collateral Damage, it is that 2010 and 2011 will see the situation getting bleaker before it gets better, in many analyses disastrously so. It’s certainly not over, and no one who even vaguely understands money and the markets could have thought it was.

Well, it’s true that was the consensus. But as someone who perhaps vaguely “understands money and the markets” (*cough*) I was:

• Questioning what rational investor wasn’t buying [March 2009]
• Suggesting one should buy shares in the bear market [April 2009]
• Pointing to ongoing permabears in the recovery [October 2009]
• Calling the end of the UK recession [February 2010]

Please note that I am not some sort of genius, or always right. I was buying shares in 2008, too soon, and explaining why I thought there was good logic in doing so (and I stand by that). I don’t claim to have timed the bottom in that post in March, except by accident. Shares could have been lower today than back then, if the dice had fallen differently. Easily.

What I do try to do though is fight this war, not the last one. At the moment inflation is more of a worry than deflation, for instance. And half the problems in this book are no longer relevant (yet new problems are).

Doom laden pronouncements like the one I quoted above are endemic in market panics, but since the depths of the crisis he wrote about:

• The S&P 500 has doubled
• Gross World Production (GDP for Earth!) grew 4.6% in 2010
• The IMF estimates it will grow by 4.4% in 2011

So the markets have recovered and the World Economy is growing, too. A good thing the editors of doom-laden compilations aren’t calling the shots!

Indeed, a recent survey of hedge fund managers found 75% think we’re already mid-way through the new economic cycle:

Leaving aside Collateral Damage’s lamentable predictive powers, I haven’t read all the essays yet, but some are quite good historical records.

A few are plain silly though. Typical of the latter is the confused neo-Marxist rant disguised as reason from Danny Boyle of the New Economics Foundation, who argues against things like property rights (hm, tell that to Hernando de Soto) and says economics doesn’t value the environment.

The latter is a particular bugbear of mine – you might as well say mathematics doesn’t value pandas, because it shows their numbers are declining.

Economics analyzes the distribution of goods and services. If it doesn’t put a value on the environment, it’s for the rather more unfortunate reason that human beings don’t value it.

Still, it’s more interesting to read what you don’t already believe sometimes, and Collateral Damage is good for that. Plus there’s plenty that’s fine but dated; it needs to gestate for a while and it’ll be useful historical evidence.

[continue reading…]