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Don't ignore the inflation threat

This article appeared in the July 2013 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.

The only real hedge for long-term investors is inflation-linked government bonds.

Photo of Elizabeth Moran By Elizabeth Moran, FIIG Securities

Do you remember the 1970s and 1980s when annual inflation was regularly above 10 per cent? In a high inflationary environment, the prices of goods and services increase rapidly, and these conditions are particularly damaging to investors because they reduce purchasing power. This is particularly important to those approaching, or in, retirement:

  1. Retirees spend a greater proportion of their income on goods and services that are linked to inflation - food, electricity and health services.
  2. They do not have the protection of a rising income to hedge against inflation and must rely on their investments.

I am not sure if the conditions are building for another inflation spiral, but I am sure it is worth considering the risk and trying to protect your portfolio against inflation.

The only direct, 100 per cent hedge against inflation is inflation-linked bonds (ILBs). Their returns are linked to the consumer price index (CPI); as the CPI rises and falls, so too does the value of the bonds and the interest you earn.

How ILBs work

A simple example. Assume an ILB is issued with a $100 face value and has the following characteristics:

  • Known 4 per cent fixed interest payment (or coupon)
  • Matures in three years
  • Inflation is running at 3 per cent per annum

The capital price of the ILB would rise from $100 to $103 in year one (in fact it is calculated four times a year, with change in inflation recorded on a quarterly basis, to coincide with the CPI release date). In year two the adjusted capital price would be $103 + $3.09 = $106.09, and in year three $106.09 + $3.18 = $109.27 (Note: calculations are rounded to two decimal points).

The issuer would therefore pay the holder $109.27 at the maturity of the bond.

Using a simplistic scenario where interest is paid annually in arrears (noting that in reality it is paid quarterly); it is calculated at the fixed 4 per cent coupon rate on the inflation-adjusted capital price of the bond. In the third year, for example, the interest payment would be $4.37 (that is 4 per cent times the adjusted capital value of $109.27).

The investor therefore receives income in two ways:

  1. If inflation rises, so does the adjusted capital price. If inflation was 3 per cent in year one, the index factor increases the value of the bond by 3 per cent.
  2. The interest (coupon) return, while fixed, is paid on the growing adjusted capital value, assuming inflation is positive.

If inflation were to rise to 10 per cent, as in the '70s and '80s, the compounding effect of these bonds really comes to the fore. The return would be approximately a 10 per cent increase in capital value plus the 4 per cent fixed coupon on $110, equating to $4.40. Your capital would be building quickly under these conditions.

What inflation-linked bonds are available and how to buy them

Inflation-linked bonds are issued by Commonwealth, state and territory governments as well as corporations.

In late May, five Commonwealth ILBs, known as Exchange-traded Treasury Indexed Bonds (TIBs) became available through ASX (see Table 1 below).

(Editor's note: To learn more about the features, benefits and risks of exchange-traded Australian Government bonds, do the free ASX online course.)

This is great news for investors because it makes buying and selling easy. Exchange-traded Treasury Indexed Bonds (TIBs) can be purchased in single units, each worth $100 face value. It is important to note that investors in these have all the beneficial rights to the bonds but they are issued as CHESS Depositary Interests. One unit holding of an eTIB provides beneficial ownership of $100 face value of the Treasury Indexed Bond over which it has been issued.

In the table below, the first column shows the ASX code for the security, the second shows the maturity date, the third the current yield over and above inflation. So the first TIB is effectively trading at CPI + 0.813 per cent. The current face value column shows what the $100 original face value is now worth following years of indexation (that is the capital-indexed value). The second last column is the current purchase price of the bond and the final column is the minimum face value that can be purchased on ASX.

If we use the first bond as an example, it was first issued in 1994, so is a long-dated bond nearing maturity. The face value has grown from the $100 issue value to $167.51 and if the Commonwealth had to repay investors on 19 June 2013, this is the amount it would pay. Looking at the same bond, the purchase price is higher than the current face value, which means the bond is trading at a premium, so investors are willing to pay more for the interest (coupon) on offer and the inflation protection.

Assuming you buy that bond and need to sell it before maturity, there is a chance you could lose money if inflation and interest expectations (among other factors) change. The purchase price could decline and potentially fall below the current face value.

Table 1: Exchange Traded Treasury Indexed Bonds

Table 1: Exchange Traded Treasury Indexed Bonds table

Source: FIIG Securities, ASX
 Prices accurate at 19 June 2013

Generally, because Commonwealth Government bonds are very low risk, they pay low returns. However, ILBs issued by corporations (see Table 2 below) are higher risk than TIBs but offer much higher returns. (Editor's note: These corporate ILBs are not traded on ASX). They are only available through the over-the-counter market where you need a broker. The Sydney Airport ILB, maturing in November 2020, is trading at CPI + 4 per cent, and the longer-dated November 2030 at CPI + 4.35 per cent.
 
Table 2 - Corporate Inflation Linked Bonds

Table 2 - Corporate Inflation Linked Bonds

Source: FIIG Securities
Prices accurate at 19 June 2013
Note: All of these bonds are available to retail investors.

Benefits of inflation-linked bonds

  • 100 per cent protection against inflation, which no other security can offer.
  • Certainty of income and repayment of principal at a known date.
  • Potential for capital gain. Rising inflation would result in higher demand for these bonds and would probably push the price up. Other factors may also push the price up, such as a "flight to quality" for eTIBs because the Commonwealth Government has the lowest-risk AAA credit rating.

Risks of inflation-linked bonds 

  • Potential for capital loss if purchased at a premium and/or investors need to sell the bonds before maturity.
  • Deflation would see the capital value of the bonds decline but most have a clause limiting the return to investors at maturity of the original $100 face value.

Because inflation-linked bonds are the only direct hedge against inflation, I would recommend every investor includes them in their portfolio.

About the author

Elizabeth Moran is Director of Education and Fixed Income Research at FIIG Securities, a specialist fixed-income broker. She has been with FIIG for five years. Her previous experience includes positions at Rapid Ratings, NatWest Markets and BP Oil in London, and Commonwealth Bank.

ASX information on inflation-linked bonds is available. FIIG information on inflation-linked bonds is available.

From ASX

To learn about the features, benefits and risks of listed fixed-interest products, do the ASX free online interest rate securities course.


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