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CIBs and IABs

by Gavin Madson | Dec 05, 2012

Capital indexed bonds

As the title suggests, capital indexed bonds (CIBs) have their capital, or the principal amount of the bond outstanding, indexed (usually quarterly), with the revised indexed capital amount due for repayment at maturity. If you had a bond with a one year maturity (bought for $100) and inflation increased at 3% for the year, you would have capital of $103 returned at the end of that year.

As the indexation increases the principal value of the security over time, the amount due at maturity becomes greater, so your capital is protected against the perils of inflation. The indexation process results in part of the periodic return being effectively capitalised into the outstanding principal. The interest on the bond is payable on the higher indexed capital amount, at a fixed coupon rate, so, if the above example was paying interest of 5% (assuming just one annual interest payment for this simple example rather than the normal quarterly interest payments), the 5% interest would be based on the $103 capital value (or $5.15) rather than the initial $100 investment.

Note: The capitalised value of the bond can reduce in periods of deflation, although this has only happened in eight quarters out of the last 169 (42 years) in Australia. Also there is in-built protection in most CIBs that the minimum capital returned to investors at maturity is the original $100 face value.

Indexed annuity bonds

With indexed annuity bonds (IABs) the investor receives a cashflow comprising both principal and interest, until the maturity date (that is the principal is repaid over the life of the bond rather than in one lump sum at maturity). This is an annuity, but the annuity is ‘indexed’.

The principal repayment schedule is calculated in essentially the same way as a conventional house mortgage. In the absence of positive indexation (inflation), each payment would be equal, consisting of part principal and part interest. This amount is also referred to as the base payment or ‘base annuity’. The base payments are indexed (by inflation) over the life of the asset, resulting in a steady increase of payments over the term to maturity.

As an annuity, IABs offer a higher annual cash return to investors, but no return of capital at maturity (again, as the capital is returned over the life of the bond).

CIB v IAB: key differences explained

The key difference between the two assets is the tenor of the investment. As the investor has to wait until maturity to receive the full capital value back under the CIB, its tenor will be longer than the IAB, which returns the capital gradually. The investors capital is at risk (or deployed) for longer under the CIB.

We have worked a cash flow comparison of CIBs and IABs in our detailed research paper, which you can read by clicking here.

In reality CIBs and IABs have much longer terms to maturity, but it’s much easier to show a four year cashflow than a 20 year cashflow. The CIB principal remains outstanding until the maturity date, whilst the IAB principal is returned progressively throughout the term to maturity, the IAB has a shorter tenor and subsequently a lower total cash return.

Cashflow comparison CIBs vs IABs

Cashflow comparison

The reason the total cash return is higher in the CIB is that you are being rewarded for having your capital outstanding for longer.

What is also evident from the cashflows is that, as principal is returned throughout the life of the bond under the IAB, the investor gets a much higher quarterly payment or income. This is a key for investors when deciding whether their investment needs are better suited to a CIB or an IAB.  Investors looking for higher income (cashflow) may consider an IAB better suited to their investment needs, whilst investors looking for an inflation protected capital return at maturity may prefer a CIB.

Regardless of which type of ILB you wish to invest in, they currently offer a good opportunity to diversify your portfolio and gain protection against long term inflation.

Please contact your FIIG Representative if you have any questions including a detailed cash flow of specific bonds.

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