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This article appeared in the June 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Learn how floating rate note investments can stop inflation eating into returns.

Photo of Mike Saba By Mike Saba, Evans & Partners

The Reserve Bank's most recent commentary shows it is concerned about rising inflation. It says the decline in underlying inflation after the global financial crisis has turned, and it is concerned about the inflationary effects of higher global commodity prices and manufactured prices. The RBA's main weapon to fight inflation is to raise short-term interest rates.

Investors may also be concerned about rising inflation, which would erode the purchasing power of cash, and they have limited avenues to protect themselves. Rising inflation is usually accompanied by rising interest rates, so it follows that investing in securities that give positive exposure to rising rates will offer inflation protection.

The two main choices

Investors have two main choices. First, there are securities whose return is directly linked to inflation: capital-indexed bonds, which are mostly issued by the Commonwealth and State governments. They provide their return in two parts, the first being a fixed interest rate based on the principal amount. This is usually a coupon of 2.5-3 per cent.

The second part, and the key to the inflation protection, is the upwards revision of the principal value, also termed the capital value, directly from the level of the consumer price index (CPI). This occurs quarterly in arrears and results in the capital value increasing over time by the level of CPI rises. This protects the principal amount of the investment against inflation. Importantly for these bonds in Australia, the capital value cannot go under $100, even in a deflationary environment. The total return over time is then the principal value indexed by the inflation rate, plus the coupon.

Capital-indexed bonds are usually long term, so investors can get long-term protection against inflation. Because they are traded in parcels of $500,000 in the institutional money market, it may be hard for retail investors to access them.

Accessibility

A more accessible alternative to get inflation protection is to hold bonds that give exposure to rising interest rates, based on the premise that inflation is accompanied by higher rates. These are called floating-rate bonds, or notes (FRNs).

Floating means that the coupon payments are directly linked to the level of short-term rates, usually the 90-day bank bill rate. Each FRN pays a fixed margin over the bill rate, with the rate adjusted at each regular payment date. In this way the return is quickly adjusted according to short-term rates. Many floating-rate bonds and hybrids are listed on ASX and all give exposure to rising interest rates. Conversely, if interest rates fall, the income will also fall.

An example is the senior-ranking CommBank Retail Bond issued by CBA, with a face value of $100 (ASX code CBAHA). These floating-rate bonds pay a return of 1.05 per cent above the 90-day bank rate. A bank bill rate of 5.0 per cent would give an annual yield of 6.05 per cent (the quarterly payment being $6.05/4).

As short-term rates rise (after an RBA rise or in anticipation of one), the return to the investor increases. Hence, in an inflationary environment with rising inflation rates, the return from the FRN rises to compensate the investor for the effects. Despite relying on the premise that rates will rise with inflation, getting inflation protection in this way is sometimes more efficient than using a capital-indexed bond, because the FRN will respond more quickly than the slow increase in the principal of a capital-indexed bond.

Also, if inflation is low, the capital-indexed bond return will be just above the low coupon, whereas the FRN return will be higher as interest rates will be above inflation, with the margin adding further return. There are more than 30 FRNs trading on ASX, giving investors a range of company and margin alternatives. Trades are as for shares, in large or small parcels.

FRNs on ASX are issued by banks and many large companies. Expanding the CBA example, there are three CBA hybrids paying various floating-rate margins with different maturity profiles, adding to alternatives from CBA for investors to get inflation protection through FRNs.

Other advantages with FRNs

There are some other advantages in holding FRNs compared to other interest rate products. Term deposits have their place, but they pay a fixed rate and hence there is no benefit if interest rates rise. Some investors might try to overcome this by using short-dated term deposits, but there is no guarantee banks will re-offer the same rates on these. Buying a high-quality floating-rate bond overcomes this. The level of margin the FRN pays over the bill rate will vary depending on the issuer. The usual credit criteria for investing in any bond still applies: the investor must be comfortable about the company's prospects and its ability to repay the bond at maturity.

With RBA inflation forecasts having been revised upwards and its proactive stance that seeks to ward off inflation by increasing rates in anticipation, rate rises in the next few quarters look likely. Indeed, the RBA has factored rate rises into its forward estimates of inflation. FRNs will give excellent exposure to rate rises as a result of inflation. In any case, holding FRNs has its place in any interest rate portfolio, and the added benefit of inflation protection gives investors another reason to consider them.

About the author

Michael Saba has covered Australian hybrid securities for more than 15 years at a number of Australian broking houses. He specialises in analysis and sales of derivatives to institutional clients, and polled No. 2 in his sector in the 2009 BRW East Coles survey. He is Head of Derivatives at Evans & Partners in Melbourne.

From ASX

ASX Interest Rate Securities provides useful information for those who want to learn more about fixed-income products, such as:

  • Corporate bonds
  • Floating notes
  • Convertible notes
  • Hybrid debt securities.

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