by
Elizabeth Moran | Jun 26, 2013
Do you remember the 1970s and 80s when inflation was regularly above 10% per annum? In a high inflationary environment, the prices of goods and services increase rapidly. These conditions are particularly damaging to investors as they reduce purchasing power, which is particularly important to investors approaching or in retirement as:
- Retirees spend a greater proportion of their income on goods and services that are linked to inflation, think of food, electricity and health services
- They don’t have the protection of a rising income to hedge against inflation and must rely solely on their investments
Are the conditions building for another uncontrollable inflation spiral? I’m not sure, but I am sure that it’s worth considering the risk and trying to protect your portfolio against inflation.
The only direct, 100% hedge against inflation are inflation linked bonds (ILBs).
ILBs are bonds that have returns linked to the Consumer Price Index (CPI). So, as the CPI rises and falls; so too will the value of the bonds and the interest that you earn.
How ILBs work
A simple example would be as follows:
Assume that an ILB is issued with a $100 face value, it has the following characteristics:
- known 4% fixed interest payment (or “coupon”)
- matures in three years
- inflation is running at 3% per annum
The capital price of the ILB would rise from $100 to $103 in year one (in fact this is calculated four times a year where the increase in inflation is recorded on a quarterly basis, to coincide with the CPI release date). Then, in year two the adjusted capital price would be $103 + $3.09 = $106.09 and in year three $106.09 + $3.18 = $109.27 (Note: calculations are rounded to two decimal points).
The issuer would therefore pay the bondholder $109.27 at the maturity of the bond.
Using a simplistic scenario where interest is paid annually in areas (noting that in reality it is paid quarterly), the interest is calculated at the fixed 4% coupon rate on the inflation adjusted capital price of the bond. So, in the third year for example, the interest payment would be $4.37 (that is 4% x the adjusted capital value of $109.27).
Hence, the investor receives income in two ways:
- If inflation rises, so does the adjusted capital price. If inflation was 3% in year one, the index factor increases the value of the bond by 3%
- The interest (coupon) return, while fixed, is paid on the growing adjusted capital value, assuming inflation is positive.
Now, if inflation were to rise to 10% recorded in the 70s and 80s, the compounding effect of these bonds really comes to the fore. The return to you would be approximately a 10% increase in capital value plus the 4% fixed coupon on $110, equating to $4.40. Your capital would be building quickly under these conditions.
What inflation linked bonds are available and how do I buy them?
Inflation linked bonds are issued by the Commonwealth and state and territory governments as well as corporations.
As of late May, five Commonwealth government ILBs became available through the ASX (see Table 1). This is great news for investors as it makes buying and selling easy. Exchange traded Treasury Indexed Bonds (eTIBs) can be purchased in single units, with each unit worth $100 face value. It’s important to note that investors in these bonds have all the beneficial rights to the bonds but they are issued as CHESS Depositary Interests. One unit holding of an eTIB provides beneficial ownership of $100 face value of the Treasury Indexed Bond over which it has been issued.
Working through the table below, the first column shows the ASX code for the security, the second shows the maturity date, the third the current yield over and above inflation, so that the first eTIB is effectively trading at CPI + 1.074%.he current face value column shows what the $100 original face value is now worth following years of indexation (that is the capital indexed value). The second last column is the current purchase price of the bond and the final column is the minimum face value that can be purchased on the ASX.
If we use the first bond as an example, it was first issued in 1994, so is a long dated bond nearing maturity. The face value has grown from the $100 issue value to $167.51nd if the Commonwealth government had to repay investors on 25 June 2013, this is the amount they would pay. Still looking at this same bond, you’ll see that the purchase price is higher than the current face value, which means that the bond is trading at a premium, so investors are willing to pay more for the interest (coupon) on offer and the inflation protection.
Assuming you buy that same bond and need to sell it prior to maturity, there is a chance you could lose money if inflation and interest expectations (amongst other factors) change. The purchase price could decline and could potentially fall below the current face value.
Table 1
Prices accurate as at 25 June 2013
Generally, because Commonwealth government bonds are very low risk they pay low returns. However there are a number of ILBs that are issued by corporations and available to retail investors (see Table 2 below). These bonds are higher risk than the eTIBs, but offer much higher returns. They are only available through the over-the-counter market where you need to find a broker, but illustrate the high returns on offer. The Sydney Airport ILB maturing in November 2020 is trading at CPI + 4.30%nd the longer dated November 2030, CPI + 4.75%
Prices accurate as at 25 June 2013
Note: All of these bonds are available to retail investors
Benefits
- 100% protection against inflation, which no other security can offer
- Certainty of income and repayment of principal at a known date
- Potential for capital gain. Rising inflation would result in higher demand for these bonds and would likely push the price up. Other factors may also push the price up, such as a “flight to quality” for the eTIBs as the Commonwealth government has the lowest risk AAA credit rating
Risks
- Potential for capital loss if purchased at a premium and / or investors need to sell the bonds before maturity
- Deflation would see the capital value of the bonds decline but most have a clause limiting the return to investors at maturity of the original $100 face value
Inflation linked bonds are the only direct hedge against inflation and I would recommend every investor includes them in their portfolio.
For more information please see http://www.asx.com.au/documents/products/AGB_Investor_Information_Statement_Exchange-traded_Treasury_Indexed_Bonds.pdf and https://www.fiig.com.au/docs/fiig/inflation-linked-bonds_essentials-guide.pdf?sfvrsn=0
Prices are indicative and subject to the availability of offers. FIIG does not make a market in these securities.