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How to get what you need from inflation linked bonds

by Ryan Poth | Nov 18, 2014

A common misconception among investors is that all inflation linked products provide essentially the same type of protection against inflation. However, there are important differences in the various securities and also in the requirements of individual investors.

Some seek mainly to protect their income and some to protect the value of their capital. This article identifies the best strategies for investors using inflation linked bonds to achieve their personal goals.

The discussion will centre on the cashflows generated by the bonds with no accounting for market fluctuations or changes in the assumed rate of inflation. We assume inflation runs at 2.50%, being the mid-point of the Reserve Bank of Australia’s target.

My aim is to answer three key questions:

  1. How do Capital Indexed Bonds (CIBs) and Indexed Annuity Bonds (IABs) differ?
  2. What drives investment in inflation linked bonds?
  3. How can I choose what is right for me?

How do Capital Indexed Bonds (CIBs) and Indexed Annuity Bonds (IABs) differ?

The most common types of inflation linked bonds in the Australian market are Capital Indexed Bonds (CIBs) and Indexed Annuity Bonds (IABs). The nature of these products makes them more suitable for some strategies and less so for others. It is important that investors recognise their reasons for investing in these securities and choose the right strategy for that goal.

Capital Indexed Bonds (CIBs):  Capital Indexed Bonds generally pay a relatively low interest rate and incorporate the rate of inflation into the value of the principal so the principal grows with inflation. Interest is paid based on the indexed value of the principal, and at maturity the final indexed value of the principal is repaid to the investor. The effect of this is twofold:

  1. Interest increases each quarter by the rate of inflation, but is generally lower than other fixed income investments.
  2. The value of the principal increases each quarter by the rate of inflation, returning a greater amount of cash upon maturity or sale of the bond.

CIBs generally suit investors who are seeking maximum inflation protection for their capital and are particularly attractive when the bond is purchased at a discount to its indexed face value. The following two charts show the cashflows and value of the principal on the two Sydney Airport Capital Indexed Bonds with 2020 and 2030 maturities.

Assuming you invested approximately $100,000 in each bond, the projected cashflow and principal value is shown in Figure 1 below.

Figure 1

The comparative steepness in the two graphs (principal value) shows that the 2030 provides better protection, not just because it is longer dated but because it is trading at a discount to its indexed face value, further compounding the indexation effect on the principal value.

Indexed Annuity Bonds (IABs): Indexed Annuity Bonds have a predetermined paydown schedule, much like a mortgage, but with an additional factor in that each (quarterly) payment increases by the rate of inflation. This allows the inflation effect on the principal to be realised along the way, but leaves no principal value remaining at maturity.

IABs generally suit investors who are seeking greater inflation adjusted cashflows over the term of the bond, and those cashflows are greater for shorter term bonds (as with any other annuity). The following two charts show the cashflows and value of the principal on the short dated Praeco Indexed Annuity Bond (2020) and long dated Plenary Justice (PJS) Index Annuity Bond (2030).

Figure 2

Assuming $100k is invested, Figure 2 shows that the shorter dated Praeco IAB generates much higher cashflow, but for a shorter term. Both securities are repaid over the life of the bond and there is no lump sum returned at maturity, rather just a final cashflow payment.

What drives investment in inflation linked bonds?

There are basically two drivers that promote investment in inflation linked bonds:

  1. Protect the value of your capital against inflation
  2. Maximise your cashflow in line with inflation

Most investors’ needs fall somewhere between the two drivers listed above.

A typical investor wanting to protect capital would be an SMSF in accumulation phase. They want to assure the value of the invested dollar increases with the rate of inflation, with the maturing value reflecting the accumulated effect of inflation. Ongoing income from the investment is a secondary concern.

In the second point, investors that most commonly want to maximise cashflow are those in pension phase. The maturing value of the investment is secondary.

How can I choose what is right for me?

With the two Sydney Airport CIBs (and occasionally a handful of others when available) and over 10 IABs to choose from, there are many portfolio combinations to achieve the best balance of cashflow and capital protection to suit your needs.

As two simple examples of how these securities can be combined, the following charts show combinations of the 2020 bonds and the 2030 bonds that achieve the following results:

  • Invested value of approximately $100,000
  • Maturing principal value of approximately $100,000
  • Cashflows that more closely match normal fixed income cashflows, with the additional benefit of rising with inflation

Figure 3
The 2020 combination invests approximately $100,000 across the Sydney Airport and Praeco 2020 bonds.

The 2030 combination invests approximately $100,000 across the Sydney Airport and Plenary Justice 2030 bonds.

In each of these examples, the initial running yield (income) is around 5.25% of the invested value.  This is more in line with a typical fixed income investment and increases each quarter along with inflation. This is similar to a floating rate note, whose income fluctuates with short term interest rates, with one important difference: the income level is floored at the current level each quarter (assuming inflation remains positive).

So while the income on a floating rate note can increase and subsequently decrease as interest rates rise and fall, the running yield on these inflation linked bond combinations will constantly rise, unless inflation turns negative.

Also note the curvature of the principal value, as the degrading value of the IAB overtakes the accreting value of the CIB. This is particularly noticeable in the 2030 combination, which is interesting as it implies that the investor can hold this combination for roughly the same period of time as the 2020 combination (i.e. to 2020) and liquidate the bonds for $105,000 consideration.

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