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What is an inflation linked bond?

by Dr. Stephen Nash | Mar 13, 2013

Inflation linked bond (ILBs) or ‘linkers’ as they are sometimes colloquially referred too, are bonds that have cashflows linked to inflation. There are two main types of ILBs in Australia:

  • Capital indexed bond (CIB)
  • Indexed annuity bond (IAB)

Capital indexed bond (CIB)
CIBs pay a pre-determined coupon based on a capitalising principal amount where the capitalisation/indexation is a function of inflation. The indexation factor is usually based on the rate of consumer price inflation (CPI) as reported by the Australian Bureau of Statistics. Interest is payable on the then current indexed capital amount at a fixed coupon rate. As the inflation indexation increases the principal value of the security over time, the amount due at maturity becomes greater.

The indexation of outstanding principal is based on lagged movements in the relevant price series; for example, the indexation of the coupon in November, under the reserve Bank of Australia formula, is based on the average quarterly increase of the March and June quarters. This is significant in assessing the strength of the hedge against inflation and the potential return.

The indexation process results in part of the periodic return being effectively capitalised into the outstanding principal. The investor is accordingly raising his or her credit risk exposure to the issuer. During negative periods of inflation the coupon will be paid on a decreasing principal. However, under the Australian system, the final payment can never be less than the original capital value at issue, usually $100.

Working example

If a CIB was issued for three years and inflation was 3% per year for the three year period, the capital price would rise from $100 to $103 in year one, where the increase in inflation is recorded on a quarterly basis, so as 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. The issuer would therefore pay the bondholder $109.27 at the maturity of the bond.

Coupons would be based on the new adjusted capital price, so if the coupon was 4%, at the end of the three year period, the coupon would be $109.27 x 4% = $4.37. Hence, the investor receives income in two ways:

  1. 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%.
  2.  The coupon return, which varies depending on the credit quality of the issuer. Australian government ILBs will have low coupon margins whereas higher risk corporate issuers will offer higher coupon margins. There are ILBs available to satisfy a range of risk/reward appetites.

The total return in our example would be the sum of the increase in adjusted capital price of around 3.0%, plus the real yield (or coupon margin) of say 4.0%, providing a total return of around 7.0% per annum.

As the principal value increases over the life of the bond, CIBs may suit SMSF/investors in accumulation phase.

Indexed annuity bond (IAB)
With an IAB, the structure of the cashflow coupon payments consist of a principal and interest component a fixed real interest rate. The principal repayment schedule is calculated in essentially the same way as a conventional mortgage; that is, in the absence of inflation, each payment is 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 bond, resulting in a steady increase of payments over the term.

The principal or face value of an IAB is returned over the life of the bond to the point that no principal remains upon the final payment date/scheduled maturity date. This is the opposite of a CIB where the principal value increases over the life of the bond. As such CIBs represent a higher refinance risk than IABs. With an ever reducing amount of principal outstanding, IAB credit risk is considered to reduce over time.

IABs may suit SMSF/investors in pension pay down phase or those looking for higher cashflow investments.

Who needs ILBs?
Most investors have savings but fail to insure those savings against the threat of inflation. ILBs are the only product linked to the CPI which provides a direct hedge against inflation.  Floating rate notes (FRNs) offer some protection against inflation as the coupon, which is tied to a benchmark (usually BBSW) is adjusted quarterly.

Investors need to remember that the cost of living rises with inflation.  When expenses rise, ILBs keep pace with the increase while savings held in a bank account do not. Importantly, the benefit of ILBs as an instrument for meeting future streams of inflation linked expenses tends to increase in proportion to time, because inflation regularly erodes the spending power of savings and the cashflows of fixed rate bonds, which do not increase based on inflation.

As detailed above, CIBs and IABs have quite different cashflow characteristics and investors should consider their circumstances before deciding which is appropriate for them.

Issuers of ILBs in Australia

The largest issuers of ILBs in Australia are the Commonwealth and State Governments. Banks and corporates, particularly infrastructure companies and public private partnerships (PPPs), are also regular issuers of ILBs.

Some of the main issuers are detailed in the following graphic:

Some key terms to understand when considering ILBs investments:

  • Real yield is the annual return in excess of inflation. For example, if inflation is assumed to be 2.5% over the life of the bond and the real yield is 4%, then total return will be inflation plus the real yield, that is 2.5% + 4.0%  = 6.5%
  • CPI is the Australian Consumer Price Index and measures quarterly changes in the price of a 'basket' of goods and services which account for a high proportion of expenditure by the Australian population
  • Index factor is the factor that adjusts the capital price to inflation. For example, if the index factor was 1 at the start of the year and inflation was 3%, it would be 1.03 at the end of the year. This change means that the bonds will pay a coupon based on the face value times the index factor; in year two this would be $103, so a coupon of 4% is paid based on the higher capital amount in year two

How can I access ILB?
The vast majority of bonds are traded over-the-counter (“OTC”). Brokers (such as FIIG) can act on your behalf to buy and sell ILBs. Some State and Commonwealth Government ILBs can also be purchased directly from the issuer.

For more information on ILBs, please contact your FIIG representative or call 1800 01 01 81.