Investors are waking up to the reality that it is not possible to ignore the impact of inflation when calculating the returns on their investments.

With the continued rise in the cost of goods and services, inflation has crept up on them and eroded the value of their money.

The rising prices of essential items such as food, transport and utilities mean that you can now buy less with $10 than before.

For instance, the full-year inflation forecast for Singapore was recently raised to between 5 and 6 per cent.

To enjoy 'real' returns, your investments should be in instruments that yield returns above 6 per cent. So if the investment rate of return is 10 per cent and inflation is 6 per cent, your 'real' returns work out to be only 4 per cent.

New on the market are inflation-linked bond funds.

These funds are typically positioned as instruments that help investors hedge against inflation. In recent weeks, the Singapore market saw the launch of two such bond funds. They are the HSBC Emerging Markets Inflation-Linked Bond fund and Fidelity Global Inflation-Linked Bond fund.

They come after a long break following the last such fund, the Schroder International Selection Fund's Global Inflation-Linked Bond fund, which was introduced here in 2004.

While the Schroder and Fidelity funds are available to retail investors, the HSBC Emerging Markets Inflation-Linked Bond fund is restricted to the well-heeled and

HSBC's Premier customers who have at least $250,000 with the bank.

What are inflation-linked funds?

Conventional bonds come with an initial principal amount and offer a regular stream of income or 'coupon'. The latter is based on a fixed payment rate.

Although they offer a steady form of return with the principal amount repaid at maturity, both the value of the principal amount and 'coupons' will still be subject to erosion by a rising inflation rate.

So if the coupon rate is 4 per cent a year but the annual inflation rate is 6 per cent, the value of the investment would be eroded by 2 per cent a year.

What sets inflation-linked funds apart from traditional bonds is that both the initial principal amount and the coupon payments are indexed to the inflation rate.

The fund is structured in such a way that the principal amount and the coupon will rise in value at the same rate as inflation. This means that as the principal rises with inflation, the subsequent coupon payments are adjusted to reflect this change.

Assume that the annual inflation rate is 3 per cent and the coupon rate is 4 per cent.

In Year One, the bond fund's principal will be adjusted according to the inflation rate, where a $100 principal will be adjusted to $103 and investors will receive 4 per cent of the inflation-adjusted principal of $103, which works out to $4.12.

In Year Two, the inflation-linked bond's principal will increase by another 3 per cent to $106.09 and investors will receive 4 per cent of $106.09, which works out to $4.24.

As long as there are price increases, even if the inflation rate moves down, the principal will rise in line with the lower rate of inflation.

Hence, the investor can potentially get back the value that is eroded by inflation.

In most countries, it is the Consumer Price Index (CPI) that is used to measure inflation.

In Singapore, the CPI is based on the average prices of more than 5,000 brands and varieties of goods.

How do inflation-linked bonds work?

An inflation-linked product aims to protect an investor's capital in times of high inflation, said Ms Yash Mishra, ipac financial planning Singapore's head of private client advisory services.

This means that it will provide a return equal to or greater than the current rate of inflation.

In the case of the HSBC Emerging Markets Inflation-Linked Bond fund, it invests in inflation-linked bonds issued by the governments in emerging economies, said Ms Audrey Wong, head of wealth management at HSBC. They include Brazil, Chile, Colombia, Mexico, Poland, South Africa, South Korea and Turkey.

As inflation in emerging markets averages about 8 per cent and the fund is aiming for a real rate of return of 3 to 4 per cent, investors are looking at a total return of potentially more than 10 per cent.

For the Fidelity Global Inflation-Linked Bond fund, its benchmark is the Merrill Lynch Global Governments Inflation-linked Bond index.

The fund invests in both government and corporate inflation- linked bonds and utilises sophisticated financial instruments such as derivatives, interest-rate swops and forex contracts. It also employs strategies like reducing holdings in markets where inflation is easing and increasing holdings in markets where inflation is rising.

The annual management fee of the Fidelity fund is 0.5 per cent a year, and that of the HSBC fund is 1.25 per cent.

Who is the product for?

Fund manager FIL Investment Management's managing director, Ms Madeline Ho, says that inflation-linked funds are a growing trend.

They attract investors who want to enjoy the certainty that their investments will retain their 'real' value over the medium to long term. They include investors who are saving for their golden years.

Institutional investors who need to match their investment income with long-term liabilities such as pension payments are also showing interest in inflation-linked funds, added other experts.

Under what circumstances are such funds suitable?

Online fund distributor Fundsupermart's analyst, Mr Wong Wei Yi, believes that such funds would do well if inflationary pressure continues to persist.

He said: 'Inflation-linked bonds are suitable for those who are keen to preserve their purchasing power regardless of the future inflation rate. As we are aware, inflation can erode savings over time if nothing is done.'

Mr Chris Firth, chief executive of wealth management firm dollarDex, believes that such funds are suitable for investors who fear high inflation and are not too concerned that they need to achieve very high returns.

How much of a portfolio should be made up of such funds?

According to OCBC Bank wealth management head Nicholas Tan, the exact proportion of such funds in one's portfolio should tie in with the investor's risk profile.

Mr Wong and wealth management firm New Independent's senior consultant, Mr Michael Chee, said that inflation-linked bonds can be part of one's investment portfolio, but suggested capping the exposure to between 10 and 20 per cent.

For investors who do not need to generate new wealth and are merely concerned with beating the effects of inflation, they could have 50 per cent or more of total funds in such instruments, said Mr Firth.

What are the disadvantages of investing in such funds?

What goes up may come down.

This means that if inflation is negative, then adjustments to the coupon and principal will reflect this. But as long as inflation is positive, that is, greater than zero, the adjustments to the coupon and principal will be positive, said Ms Ho.

So even if the inflation rate decreases, it would have to go negative before investors see a decline in the value of their investment. As such, inflation-linked bonds may underperform traditional bonds in a low inflation environment.

Another disadvantage is that an inflation-linked bond fund which invests in emerging markets may face the risk of volatility in emerging market currencies. If the fund is hedged, there is a cost to it, which reduces the return to the fund, said IPP Financial Advisers' investment director, Mr Albert Lam.

For example, the underlying bonds in the HSBC Emerging Markets Inflation-Linked Bond fund are denominated in local currencies such as the South Korean won, Brazilian real and Mexican peso, so they are subject to foreign-exchange movements.

Mr Lam added that investors in countries where inflation rates are very high may find inflation-linked funds that track global inflation rates less attractive. Thus, the return from an inflation-linked bond fund may not necessarily be enough to offset the inflation an investor faces in his home country.

What is the size of the inflation-linked bond market?

The market has grown significantly in the last decade, as more governments and firms came up with such products.

In 1996, the United States issued its first Treasury Inflation Protected Securities, or Tips, and since then, has been followed by France, Italy, Greece, Germany, Sweden and Japan.

The current size of the inflation-linked bond market is about US$1.5 trillion (S$2 trillion).

What are the other products that address the challenges of inflation?

The key aim of inflation-linked bond funds is to help preserve your wealth and hedge against rising prices. This means that investors who want higher returns may want to consider other investments such as equity funds, which offer potentially higher returns.

However, they do come with higher risks.

Fundsupermart's Mr Wong believes that funds investing into precious metals are a better hedge to inflation.

'Such funds on our platform include DWS Noor Precious Metals Fund and United Gold and General Fund,' he said.

Another alternative is the yet-to-be-launched DWS Global Inflation Buster fund, which German fund manager Deutsche Bank's asset management division is launching on Tuesday.

It is an equity fund that aims to invest in firms that are poised to thrive in an inflationary environment.

lorna@sph.com.sg