Some thoughts on inflation, followed by some good money reads.

For most of the past two years, it’s been wrong to be worried about inflation. It’s also been pretty lonely, as the world has piled into bonds and bought gold much more as catastrophe insurance than on fears of an inflationary spiral.

When I thought US government bonds looked absurdly overvalued in late 2008, for instance, I was right from the perspective of the poor value they offered compared to equities, but wrong to fear they’d soon suffer at the hands of inflation. In fact, deflation remained the mood music in the US throughout 2009 and most of 2010.

In late 2010, however, the musical chairs have been shifting. A strange alliance of hedge funds, ancient investors like Jim Slater, and money bloggers seemed the first to worry about inflation. As the year ends it now seems every newspaper, fund manager, and man in the street is an inflation hawk.

Perhaps the shift has come about because after years of overshooting its target, the Bank of England now says it fully expects inflation to stay above 3% throughout 2011, too.

Bank insiders can give all the interesting speeches they like about why this is consistent with policy [pdf] but the suspicion is growing that keeping interest rates at record lows in the face of inflation 50% above target isn’t just a matter of needs (i.e. raising the rate would only hurt the nascent recovery, and it wouldn’t reduce input costs) or even musts (i.e. we can’t afford to crash the housing market) but actually a deliberate action to solve these problems by inflating away the UK’s personal and private debts.

This is dangerous stuff. Normally a growing consensus in investing is a reason to consider doing or thinking the opposite, but inflation isn’t like that – the whole danger is that consensus expectations for higher inflation get embedded in the system, leading to a self-fulfilling prophecy as people take steps to prepare for it.

True, the Bank and others are surely right that with unemployment high and the debut of true austerity Britain a mere two weeks away, workers aren’t in a position to bid up wages en masse.

But these things can quickly change, and pressures are already showing up in domestic areas like rising rents (see this graph – at the bottom of the page).

Also, not worrying about rising inflation because the consequences lie down the line is a bit like not worrying about higher blood pressure because you’re too young to have a heart attack. The time to take action is when you first spot the symptoms, not when you’re 60 and short of breath.

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A common question among DIY investors is whether they should buy gilts directly or invest in a gilt fund.

The answer depends on why you’re buying gilts ¹, and on how confident you are at managing your own holdings.

Let’s step back and consider the three main reasons for owning gilts:

Diversification – Most portfolios include an allocation of government bonds, since they are more secure and less volatile than equities, and their price tends to move in the opposite direction, diversifying portfolios.

Income – Gilts pay a fixed income in twice-yearly installments, with the running yield determined by the price you first paid for them.

Security – You’ll get the par value of a gilt (invariably £100) back when the gilt matures in 5, 10, or however many years time, as specified by the gilt’s name. The UK government has honored its debts for centuries, and so gilts are generally considered a risk-free investment.

Remember: The par value of your gilts may be less than you paid for them, and you may get less than par if you sell up before they mature. See my corporate bond series for more on why bond prices fluctuate.

Whether you choose to buy gilts direct or invest via a gilt fund, you’ll be exposed to these the main factors above – but to varying degrees. Depending on what you’re holding gilts for, different factors will be more important to you.

Buying gilts directly

Gilts can be bought, held, and sold just like shares, although far fewer private investors ever do so.

Most online brokers enable you to buy and sell gilts for their normal trading fee, and the bid/offer spread is usually reasonable. (Most investors will want to hold their gilts to maturity, anyway, so won’t need to worry about selling).

Alternatively you can buy gilts from the government’s Debt Management Office. You’ll still be charged a fee, and you have to trade by post and pay by cheque, and take whatever price is prevailing for your gilts on the day, all of which is a faff. The dealing fees can be cheaper in some cases, though.

To determine which gilts you want to buy, you can use various online resources to find out bond prices and yields.

There’s no real difference between the different fixed term, fixed rate gilts except their price, their coupon (and hence their running yield), and the time until maturity.

Okay, that is actually a fair few differences, but the point is it’s not like share investing where you have to research the underlying company. All gilts are backed by the same issuer – the United Kingdom!

Advantages of buying gilts directly

• You don’t pay annual management fees to a fund manager. After your initial trading costs, there’s no more fees to pay (assuming you hold the gilt to maturity).

• You know exactly what income you’ll get every year from your gilts.

• You can ignore capital fluctuations, knowing you’ll get back the par value of the gilt if you hold it to maturity.

• You can construct your own ‘ladder’ of gilts ², to smooth out the impact of varying rates in the market.

• Individual gilts are free from capital gains tax (even outside of an ISA).

Disadvantage of buying gilts directly

• You’ll have to do your homework to understand the gilt market.

• Your gilts will rise and fall in value every day – perhaps markedly in the case of long-dated gilts.

• You’ll need a reasonable sum if you want to create a nice spread of gilts. ³.

• As your gilts mature you’ll need to spend time researching and buying new holdings.

• You may be tempted to try to trade your gilts for capital gains, which is not advisable if you’re holding them for another purpose such as diversification.

• Only gilts with five or more years left to run when you buy can be held in an ISA.

Investing in a gilt fund

The first choice with a gilt fund is whether to go with a passive gilt fund or an actively managed one.

Buying a gilt ETF is a very easy way to diversify your portfolio. The iShares IGLT exchange traded fund, which holds a wide basket of gilts, is a good option.

Alternatively, there are plenty of managed gilt funds about, although you need to read the descriptions carefully to see exactly what they invest in. Many bond funds use words like ‘strategic’ and ‘alpha’ to muddy the waters; it’s too easy to discover what you thought was a UK gilt fund buying Indonesian government bonds, so be sure to read the small print.

As ever, the ETF option beats the managed funds on the all-important cost criteria. After trading fees to buy the ETF, the annual charge is just 0.2% a year.

Managed gilt funds in contrast charge big upfront fees (which can be sidestepped by using a fund supermarket) and up to 1% a year in total expenses, which is a huge amount out of your return when yields are low.

Active gilt funds also differ in performance due to their managers’ attempts to trade gilts for a profit, with some beating the market and some lagging. As usual, there’s no sure way to know which funds will do well in advance.

Advantages of investing in a gilt fund

• It’s a one-shot asset allocation decision.

• You don’t have to learn about gilts, but can instead leave it to the professionals.

• Your fund will invest across a range of maturities, and this diversification should provide a reasonable buffer against big valuation moves.

• An active gilt fund manager may also use derivatives and the like to further reduce volatility in the fund.

• You can hold your gilt fund in an ISA.

Disadvantages of investing in a gilt fund

• The diversification of your fund will not stop its value rising and falling entirely, and since it’s open-ended there’s no guarantee whether or when you’ll get back what you put in. (Compare that with a fixed term gilt that redeems at par).

• Annual costs. Even the 0.2% TER of the iShares ETF isn’t negligible in an era when yields are in the 3.5% range. As for 1% a year, ouch!

• If you choose an active fund, its return may lag the gilt market if the manager is drunk misjudges things. You might want to invest in a couple of different funds to spread this risk.

• There’s (a very small) additional risk of fraud or similar if you invest via a fund manager, versus holding the gilts yourself.

• Gilt funds are liable to capital gains tax (if held outside of an ISA).

So which is right for you?

I think most people who read Monevator are capable of buying and holding gilts directly, whether they buy via their online broker or the DMO.

And in most cases, I think buying gilts directly is the preferable route, too. It’s usually cheaper, and you can lock in the interest rate you’ll be paid for each issue, which is one big advantage of owning gilts in the first place.

You also know when you’ll get your money back – and how much you’ll get. This is handy if you know you’ll need a particular amount of money for some specific future use, such as paying Jemima’s university fees.

But pure passive investors shouldn’t sweat about taking the gilt ETF route. Funds are also the best choice if you’re too lazy or busy to dedicate time to your gilt portfolio.

The good news is that whether you buy gilts directly or invest in a gilt fund, you’ll get roughly the same diversification benefits. So the decision as to how to invest really comes down to which advantages outweigh the disadvantages for you.

1. The common name for UK government bonds[↩]
2. This is an article in its own right, but in essence you buy gilts with different maturities – say five issues with 2,4,6,8, and 10 years to run – and over the years recycle the money from gilts that mature into buying new gilts at the long end of your ladder[↩]
3. At least £10,000 I’d suggest, to be invested in five tranches of different gilt issues. £14,000 across seven issues would be a better minimum[↩]

Some musings on the investing landscape, followed by the weekly links.

Those who tout connections between the past performance of the stock market and the date on the calendar will be excited as 2010 closes.

Already we’re promised a ‘Santa Rally’ – the historical data suggests shares go up much more than down in December. The first months of a new year are invariably touted as good ones, too, before we’re told to ‘sell in May and go away’.

There may be some truths here, for all the silliness. It’s argued small cap shares do well in January, for instance, because US investors have begun a new tax year, and so feel more confident about taking risks.

But overall the human calendar is an artificial one when imposed on top of the business and investor sentiment cycle.

Think of the key periods over the past couple of years:

• The six-months of fear and loathing from the collapse of Lehman Brothers in September 2008 to the start of QE in March 2009.
• The ‘dash to trash’ rally from April 2009 to April 2010.
• The on/off sovereign bond wobble of late Spring until November.
• The ‘risk back on’ mood of the past few weeks.

None of these moves had the decency to fit to any calendar schedule. Instead, newsflow, emotion, and the underlying business cycle combined to drive valuations.

My meaningless thoughts on the market

So what sort of phase are we in now? For what it’s worth (nobody knows where we’ll go!) I’m still happy being very long shares in this climate, particularly as government bonds look so expensive.

True, with stock market writers now making a case for the FTSE rallying to 8,000, it’s hard not to suspect people are getting greedy.

But company earnings are growing strongly, balance sheets in good nick, and plenty of money still sits on the sidelines. With a P/E of 11, the UK stock market does not look expensive, and a much higher level for the index in the next 24 months doesn’t look overly fanciful.

Long-time readers may recall I suspect we’re into a new bull market, although the dramatic rise in the stock market since I wrote that in 2009 does curb what we can realistically expect from here.

Inflation is the outcome

The underlying fundamentals are changing, too. US government bonds are selling off, and here in the UK the yield on the 10-year gilt is back above 3.5%, which is higher than the yield on the All-Share – a normal state of affairs, but not something we’ve seen for a while.

Inflation expectations are rising, too. UK inflation has been ahead of target for months, despite relatively high unemployment, but it’s the emerging markets that we need to watch: At 5.1%, Chinese inflation is running at a 28-month high.

Inflation might eventually curb the appetite for emerging markets, if rates are lifted to dampen down growth. But emerging market investors should expect volatility at all times, anyway, and have a long-term strategy to invest through it, such as monthly investing into a suitable fund.

With inflation looking far more likely than deflation to me, I remain happy being very overweight UK equities. I’d probably buy more European shares, if the Euro wasn’t so strong. Ditto the US, where I’d be most likely to invest in technology stocks. A strengthening pound in 2011 would be a nice opportunity to add to overseas holdings.

I have been fiddling a bit with what I buy, in the UK, though. ¹

Income investment trusts are looking relatively expensive, for instance. I was buying these on fairly decent discounts to their Net Assets, but now some are trading at a premium. As a result I’ve already sold one big holding, and moved the money into a giant UK growth trust, which was trading at a nice discount. Others may follow.

The reason income trusts are trading at a premium – in contrast to the big discounts of two years ago – is that retail investors have grown less fearful and so will buy shares, but they really want income. As a result, the relative valuation between growth and income shares has been compressed. But it won’t stay this way forever.

If you’re a long-term investor in income trusts for the regular payouts, you can ignore all this. Just be aware that you can’t expect to always get the higher starting yield AND superior capital growth like we’ve enjoyed recently.

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1. Remember, as ever I recommend most investors are better off concentrating on asset allocation and passive rebalancing. I’m just a fool who should know better![↩]