Inflation-linked bond funds, a good buy?

I read with interest an article on inflation-linked bond funds published n Sunday Times, 20th July 2008.

With inflation escalating around the world, and much higher rates closer to home in Southeast Asia, it seems like inflation threatens emerging economies here more than the prospective of a recession. For this reason, other then the traditional oil & gas and other basic resources investment theme, inflation busting vehicles are grabbing the limelight too.

Like any hot vehicles that are created at the onset of sudden interest (bubble tea & lohan fish), which mostly under performs once the interest wanes, does inflation-linked fund belong to the same category? I will like to find out.

How Inflation-linked bonds worked

In a conventional bond, a principal is fixed at inception and the borrower promised to pay a fixed interest, typically yearly or half yearly called a coupon. For an inflation-linked fund, the principal is not fixed and actually grow at the inflation rate and the interest is calculated on the adjusted principal.

For example:

Conventional 10 year bond:
Principal: $100
Interest: 5%
=> Yearly coupon is $5 and principal recovered in 10th year is $100

If inflation rate is 5%
=> Annual return = 5%
=> Real return = 0% (5 - 5)

Inflation linked 10 year bond:
Initial Principal: $100
Interest: 5%
Inflation: 10% yearly

=> (year 1): Principal becomes $110, coupon becomes $5.50 ($110 x 5%)
=> (year 2): Principal becomes $121, coupon becomes $6.05 ($121 x 5%)
...

Since inflation rate is 10%
=> Annual return = 15%
=> Real return = 5% (15 - 10)


The idea is that whatever the inflation rate, the bond holder get the promised interest rate. If I can have access to such a bond and my aim is just to protect my wealth (I'm still trying to build some wealth to protect), I will be happy to invest in one.

How Inflation-linked funds worked

Such funds aims to protect the investor's capital in times of high inflation. Thus the primary objective is to beat the inflation; generation of real returns above the inflation is secondary. To achieve that, these funds can (not exhaustive list):

• Invest in inflation-linked bonds issued by governments in the emerging economies
• Corporate inflation-linked bonds
• Utilises sophisticated finanical instruments such as derivatives, interest-rate swops and forex contracts
  

How they actually perform

According to the article, only Fidelity Global Inflation-Linked Bond fund is available to retail investor. Hence I research a little more into it. The brochure can be downloaded here and the prospectus can be downloaded here. Since it is still relatively new, no track record is stated in the prospectus. The closest clue I can find it the following prospectus from MAS's website. The compounded annualised return is actually not very fantastic, it is about 2%.

Singapore's inflation rate (year on year changes, see my other article on inflation) normally hovers below 5% and hit an abnormal high of above 20% in 1974 and 1975. Assuming Singaore's economy stablises in the last 20 years, the annual compounded inflation rate is about 1.5%. Thus, most probably, after factoring the 0.5% mangement fee and sales charge of up to 5.25%, the fund will at most break even for investors.

Conclusion

Unless I can have access to an inflation-linked bond (which I think there's almost no possibly of losing money unless the bond issuer default), I will not consider such funds.