Some of our investors like the idea of the higher cash flows offered from Indexed Annuity Bonds (IABs) but still need a principal return at maturity. Other investors like the increasing nature of the principal value of Capital Indexed Bonds (CIBs) but wish for a higher cash flow through its life. So what if you combined the two?
What do you combine?
By combining bonds with similar maturity dates you are able to produce a ‘mini’ portfolio which provides a number of positives and very few negatives.
First let’s look at the key differences between the two types of bonds which produce their strengths and weaknesses when invested in separately:
- Cash flows – IABs will deliver a higher annual cash flow than CIBs (with the same yield to maturity) as IABs pay back both interest and principal over the life of the bond, while CIBs only pay back interest during the life of the bond with principal paid back at the end
- Return of principal – as IABs return the principal over the life of the bond, there is no final principal repayment at maturity. CIBs principal grows over time in line with inflation so the principal returned at maturity is greater than the capital outlaid when you first invest
- Exposure risk- as IABs pay down over time your exposure to the ‘credit’ decreases over time; since CIBs principal increases over time your exposure to this credit increases.
Here, we will look at combining the Sydney Airport CIB which matures in 2020 with the Praeco IAB which also matures in 2020. Both are investment grade bonds and rank senior secured in their respective capital structures.
Cash flows
For our example we will invest in $100,000 in face value of each of the bonds and we assume an average CPI inflation value of 2.5% throughout the life of the bonds (the midpoint of the RBA target range). We note however that both of these bonds are available in parcel sizes down to $50,000.
At current pricing (at the date of writing) investors would need to outlay $195,860 to buy this combined mini-portfolio, representing $70,180 for Praeco and $125,680 for Sydney Airport. The main reason for the difference in the price is that the Praeco bond has already been paying down its principal since it was issued whilst the Sydney Airport bond’s principal has been growing since it was issued.
The first quarterly payment investors receive for this combined portfolio is for $3,865, with the Praeco IAB (paying both principal and interest) contributing $2,666 and the Sydney Airport CIB (paying only interest) contributing the remaining $1,199. Over the life of these bonds this quarterly payment grows to $4,631 (consisting of $3,194 from Praeco and $1,436 from Sydney Airport).
The quarterly cash flows are shown in the graph below. Note that the cash flows to the investor grow over time reflecting the inflation adjustment and that throughout the life of the portfolio Praeco continues to contribute around two thirds of the total payment due to its paying down of principal.
Another way to think about the ongoing cash flows is that for your $195,860 initial outlay, you would receive a cash flow of $15,608 in the first 12 months and over the next seven years your annual cash flow would grow to $18,352 (in the last 12 months). After which you receive your outstanding principal. Total cash flow returned over the life is expected to be $282,388, assuming 2.5% average inflation.
Principal payout
With Praeco paying down its principal (as noted above) over the life of the bond it eventually fully amortises, or pays back the investor. As such, at maturity, the investor receives no principal repayment from their Praeco investment. This can be seen below by the decreasing dark blue column in the graph below.
At the same time, the Sydney Airport bond’s principal increases in line with inflation (CPI) with it growing from $127,600 at the time of investment to $152,869 at maturity. This increase of $25,269 in principal value partially offsets the pay down of Praeco’s principal ensuring investors get to enjoy the benefits of the higher cash flows over the next seven years, whilst still receiving a return of most of the principal value invested at maturity.
Credits
We remain very comfortable with Sydney Airport as a credit and the 2020 maturity is currently offering some of the best value of any bond in the market. Ranked senior secured and issued by one of Australia’s premier pieces of infrastructure this represents a low risk, investment grade infrastructure investment.
The key risk with the Praeco business remains the risk of refinance of its nominal bonds in 2020. With this IAB, the principal pays down to $0 at the same date as the nominal bonds mature, so there is no refinance risk for this bond (ie. you are effectively refinancing $0 at maturity of the IAB...thus no refinance risk). With the key business risk removed by the nature of the bond, all that remains is the government revenue streams and the low risk building maintenance business to manage. The Praeco IABs represent a very low risk for investors.
Summary
For the initial investment of $195,860, investors receive total cash flows over the next seven years of $282,388. $152,870 of this is returned as principal in 2020, the rest ($129,518) is returned in quarterly cash payments over the seven year period. The best of both worlds - higher running cash flows over the life of the bonds and a principal return at maturity.
Detailed cash flows are included below based on pricing current at time of writing and a 2.5% inflation assumption over the life of the bonds.
