Personal finance: Reduce the risk to your portfolio.
Inflation is the major enemy of the investor and the aim of any long-term monetary plan should be to achieve a return in excess of inflation to protect the real value of an asset.
Often referred to as the cost of living, inflation is usually measured by the Retail Prices Index.
The rate of return in excess of inflation is referred to as the real rate of return and this is what investors should be seeking to achieve when looking at returns.
There are two simple investment vehicles that can be used to provide investors with a guaranteed real rate of return over and above inflation with capital guarantees.
Index-linked Saving Certificates issued by National Savings and Investments currently offer an inflation-beating, tax-free investment for either a three or five-year fixed term. These investments should form an important part of the no-risk element of an overall portfolio.
Issue number 37 of the five-year term certificates for instance would produce a tax-free return of 4.25 per cent per annum if held to maturity and assuming inflation at 3.2 per cent over the full term.
This is equivalent to 7.08 per cent for a higher rate taxpayer and 5.31 per cent gross for a basic rate taxpayer.
The current issue number 10 for the three-year term certificate would yield 4.15 per cent tax-free, equivalent to 6.92 per cent gross for a higher rate taxpayer and 5.19 per cent gross for a basic rate taxpayer.
Although the capital guarantees both of these issues offer attractive returns, bear in mind the maximum investment for each issue is pounds 15,000.
Alternatively, for larger amounts, investors could use index linked government gilts which also promise to return inflation plus a fixed coupon (dividend) and a guaranteed capital sum if held until maturity.
As UK gilts or government bonds are guaranteed by the Bank of England, they have no default risk and the highest credit rating by Standard and Poor's of AAA. These securities have a lower default risk than an ordinary bank account.
The dividend or coupon is relatively low and is the taxable element of the overall return. The index-linked return is tax-free, and the overall combined return makes this form of investment particularly attractive to higher rate taxpayers or trustees of family trusts.
With the housing market showing increasing signs of underlining weakness, it is felt that the Bank of England will keep interest rates on hold at 4.75 per cent and rising inflationary pressures mean that rate cuts remain unlikely.
The Bank of England's role is to control inflation through its interest rate monetary policy and the RPI Index is also used to calculate the inflation return of index-linked gilts. Inflation is currently 3.2 per cent year on year as measured by the RPI Index and the Bank of England's target is to keep the index below this figure.
It is felt that inflation will remain at the top of the target range because of the rise in commodity prices, wage growth and a weaker sterling.
A portfolio of index-linked gilts would generate an estimated gross return of 4.7 per cent if the gilts are held to maturity. If the RPI Index is at 3 per cent net of 40 per cent tax, this return would be estimated at 3.7 per cent (because there is no capital gains tax on gilts) compared with 3 per cent net of tax from a 5 per cent gross interest paying bank account.
As well as offering higher returns than current gross deposit account rates for a 40 per cent taxpayer, gilts tend to have a greater liquidity. They can be sold the same day, and they have fixed returns whereas of course banks can lower interest rates with little or no notice.
Furthermore, gilts pay interest gross which can be reinvested until the tax needs to be paid. But expertise is needed constructing a suitable portfolio as fixed terms for index-linked gilts can vary widely from one year to more than 20 years.
Trevor Law is a director with Montpelier Group (Europe) Ltd, the privately-owned independent financial advisers that has just moved to a new headquarters outside Barston near Solihull. E mail: TILaw@montpeliergroup.com