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by Simon Michell | Jun 05, 2013

I am concerned about the impact of inflation on my portfolio

  • An allocation to inflation linked bonds (ILB) such as the Southern Cross Airports Corporation Pty Ltd 20 November 2030 ILB, or more commonly known as the Sydney Airport 2030 ILB, provides annual income or running yield of 3.63% p.a. (on a principal which will increase over time with inflation) in addition to indexing the value of the face value of the bond at the rate of inflation
  • Assuming an annual inflation rate of 2.5%, the above bond will currently pay an all up yield to maturity of 6.75% p.a.
  • As ILBs pay a margin over the level of inflation they are less impacted by movements in interest rates

I am concerned about the impact of higher interest rates on my portfolio

  • A floating rate note (FRN) such as the National Capital Instruments issued by the National Australia Bank (NAB Caps) provides a quarterly coupon at a fixed margin of 0.95% over current benchmark interest rates (i.e. the three month bank bill swap rate or BBSW) which is reset every 3 months. As such, the coupon payment adjusts up and down with movements in interest rates and is less volatile than a fixed rate bond
  • The NAB Caps are an unlisted or over the counter (OTC) perpetual Tier 1 hybrid with a call date of 30 September 2016, available to wholesale investors that is trading at an equivalent margin of 2.45% above three month BBSW (priced to call date in 2016)
  • Unlike many listed hybrids there is no conversion in equity risk on this security which makes it an attractive alternative to the new type of retail hybrids which are longer dated, have no step-up and contain automatic triggers for conversion to equity

I am concerned about the impact low interest rates is having on the level of income generated by my portfolio

  • By incorporating an inflation indexed annuity bond (IAB) into a portfolio you are able to increase the level of cash flow generated. This is because every quarter you receive a portion of your capital back. So instead of waiting for the date of maturity to receive your capital you receive it over the life of the IAB
  • IABs are tradable securities which can be sold prior to maturity if required. They are not a deposit
  • Your quarterly payments also provide an interest return which is indexed to the rate of inflation

I want to lock in a high income (running yield) but I don’t want to use my capital

  • The Qantas fixed rate bond pays a semi-annual coupon of 6.50% p.a. On current pricing this represents an annual income of 5.9% p.a.
  • Maturing in April 2020, and with a spend of $104,159 for a face value of $100,000, you receive semi-annual coupons of $3,250.00 until maturity at which time you receive the final coupon and face value of $100,000
  • As an investment grade senior bond this is a good defensive asset providing a solid income stream

I can get a better yield by buying Telstra or the big four bank equities

Unlike bonds, future dividends are not a legal obligation of the company and can be reduced or stopped at any time.  During the crisis the big 4 all cut their dividends (ANZ & NAB cut by 25%, CBA cut by 12%, WBC cut by 18%). Further, the capital value of shares is significantly more volatile.

I am concerned about the “bond bubble”

A bond bubble is different to an equity bubble as bonds will pay out their face value at maturity. A fall in bond prices will only affect investments in bond funds, not an investment directly into bonds that are held to maturity. For a more detailed look at the misconceptions of the so called “bond bubble” please click here.

I think listed hybrids offer better value

Hybrids exist in both the OTC and the listed market.  The OTC market generally offers better value for similar securities than the listed retail market. Wholesale and sophisticated investors who access the OTC market are operating in a far more liquid and deeper market.  So when you invest in the wholesale OTC market you gain access to the same returns as the professional investors. Further, there can be timing delays in receiving your interest payments in the listed market due to franking which does not occur in the OTC market

I don’t understand the OTC market, is it transparent

According to AFMA, in 2012, the OTC bond market turnover was 10 times the size of the equity market. Because it is used almost solely by professionals, there is little need to publish prices to the general public as all market participants can find pricing via other market participants.  FIIG can locate prices and volumes for bonds at any time and provides end of month valuations as well as publishing a weekly transparency report available on our website here

We invite planners to send any questions they have to and we will endeavour to answer your queries.

All prices and yields are as at 6 June 2013 and are a guide only and subject to market availability. FIIG does not make a market in these securities.