As central banks have boosted the money supply to avoid depression, the risk is that the process could cause inflation, so this article examines how to guard against it.

Buying inflation-linked bonds is a little like buying car insurance: you don’t really appreciate the value of what you have until you have a car accident.

So, while inflation is not a clear and present danger to the economy right now, the possibility of a car crash further down the road is increasingly preoccupying the minds of investors. And with good reason - recent government policies to resolve the global credit crisis and stave off recession are likely to put future upward pressure on prices.

Fortunately, inflation-linked bonds provide an effective, low volatility investment that compensates investors for rising prices. This year, some contrarian investors have already profited from buying into inflation-linked bonds at distressed levels. In the second half of 2008, inflation expectations collapsed as economies slowed dramatically, while a flight to the most liquid assets caused a sharp rise in real yields, as investors sold inflation-linked bonds in favour of conventional government bonds.

At this point, the watchword was deflation and investment in inflation-linked bonds was very much a contrarian trade. Now, there is growing body of fundamental reasons for building a position in inflation-linked bonds within any balanced portfolio.

Breakevens - which reflect the difference in yield between a nominal government bond and an inflation-linked government bond of the same maturity - are usually a good measure of expected inflation levels. Taking up the insurance theme again, when accidents are expected to be rare, the cost of the insurance premium is low. Likewise, when inflation expectations are low, the cost of the inflation premium on inflation-linked bonds is also low. Currently 10-year US inflation breakevens are trading at 1.81 per cent.

So, why should we expect a worse than discounted outcome for inflation? The desire to reflate the economy has prompted several policy makers to implement “quantitative easing” measures, which aim to increase money supply and reinvigorate credit markets. While, it is likely that these monetary injections will have the desired effect, investors are justifiably concerned that this is a crude science and the unprecedented size of the stimulus could cause inflation in the world economy.

In the UK, the Bank of England plan represents 10.3 per cent of the country’s GDP and will see the Bank buy at least £125 billion (around $206 billion) of both gilts and corporate bonds. In the US, the numbers are even bigger with the Federal Reserve buying treasury and mortgage-backed securities equivalent to 12.2 per cent of GDP.

Despite the fact that growth is negative across the main economic regions and inflation levels are close to zero today, there appears to be enough stimulus in the economic pipeline to bring about a slow economic recovery coupled with moderate inflation over the next few years.

This is an attractive environment for inflation-linked bonds, which provide a real yield that protects investors from the risks of higher inflation over the next few years. Real estate investments are often seen as a good alternative inflation hedge. However, as investors have seen all too often in recent years, they are often less liquid vehicles than linkers and can be significantly more volatile.

In the same vein, while gold has been closely correlated with inflation over the very long term, the speculation risk embedded in gold investing does not make it a risk-free inflation hedge. Inflation-linked bonds, on the other hand, are largely issued by stable, high quality countries.

Within inflation-linked markets, the outlook for UK index-linked bonds is more encouraging that it has been for several years. Quantitative easing looks likely to nudge inflation upwards over the medium term, with inflationary pressures expected to reassert themselves in the latter part of this year.

Investors can profitably look beyond the UK, however. As global financial markets have become increasingly sophisticated, the mobility of capital means that, over time, real yields should converge to similar levels. Cross-country trades and cross-market strategies bring greater flexibility and potential value, while the portfolio still remains hedged against domestic inflation risks.

The Japanese inflation-linked market provides an interesting example as inflation breakevens have recently recovered from extremely distressed levels. The Japanese 10-year inflation breakeven was as low as -3.6 per cent in December last year (a level which effectively assumed deflation of 3.6 per cent per annum in Japan for the next 10 years). Deflation in Japan has not been worse than -2 per cent (and that only for a brief period of time). So, unless Japan dips into a worse deflation than ever before, for a full ten year period, holding Japanese inflation-linked bonds over the longer term is a very attractive proposition.

Overall, the inflation-linked market has performed well in the year to date, shedding some of the volatility we saw last year. Since governments are throwing huge sums at stimulating economic growth and inflation, anyone who has not yet hedged this key portfolio risk, should start considering inflation-linked bonds as an insurance policy.