This article appeared in the March 2014 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.
By Mike Saba, Evans & Partners
There are expectations that inflation is going to rise. Recent consumer price index (CPI) figures were higher and many believe that central bank monetary policy stimulus, especially in the US, will eventually be inflationary. The past two Australian CPI results have been above market expectations. For the December half, core inflation was sitting at an annual rate of 3 per cent.
We are all familiar with the line, "inflation eats into your purchasing power", but it is very easy to dismiss the effects. Imagine the news of the day is that a new tax is to be introduced that will take 3 per cent of your total spending dollars away each year. It would be front-page news for days.
Well, that's what inflation does. If running at 3 per cent per annum we would need an additional 3 per cent income to buy the same quantity of goods. When inflation is low we do not tend to pay too much attention. But an increase in inflation can really hurt income investors.
If holding money in cash, or a fixed-rate bond, much of the returns may be eroded. For example, the current yield on a 2020 fixed-rate Commonwealth Government bond is 3.54 per cent. If inflation was running at 3 per cent per annum until 2020, the real yield would be very low.
Evans & Partners chief investment officer Mike Hawkins feels that with the retreat in the Australian dollar, inflation pressures will persist in the first half of 2014. The next CPI result is due in mid-April and a continuation of recent increases will focus the markets attention on inflation and the importance of investors looking to protect the value of their wealth and income for the medium to long term.
Inflation has a negative compounding effect on net wealth. Concerned investors need to hold assets that will rise in value with inflation, and protect their income via securities that provide more return when inflation rises.
The role of bonds to safeguard against higher inflation
(Editor's note: ASX glossary explains key interest rate securities terms).
There are two general types of securities that can provide inflation protection:
- bonds that have returns specifically linked to inflation changes;
- those whose coupons are set relative to short-term interest rates (such as floating-rate notes).
This second group protects on the premise that interest rates will rise in an inflationary environment, and hence the coupons rise. This premise is OK, but not set in stone.
In the first case, however, there are several security types that provide specific inflation protection. A prime example is inflation-linked bonds (ILBs). These pay a set coupon rate on their face value, but the face value is adjusted each quarter for the rise (or fall) in the CPI. For example, the December-quarter CPI rate was 0.80 per cent.
An ILB with a face value of $100 would have had the face value adjusted to $100.80. This adjustment occurs each quarter. It also has a compounding effect (just as inflation has a compounding effect against your purchasing power). The coupon rate is now paid on this increased face value. Hence the investor gets an increasing cashflow plus their capital compounding at the inflation rate.
ILBs are issued by the Commonwealth Government - Treasury indexed bonds (TIBs) - and various corporates. They typically have long maturities, as investors are usually seeking inflation protection for five to 20 years. Inherent in the pricing of an ILB is the markets' future view of inflation. The often-quoted yield on an ILB is the "real yield" - the yield after inflation.
Adding an inflation expectation to the real yield produces the final yield, incorporating the rises in the face value. For example, the Commonwealth Government 2030 TIB has a real yield of 1.9 per cent. Adding an inflation expectation of 2.5 per cent per annum would give a final yield, or yield to maturity, of 4.40 per cent.
Easy access to ILBs
Investors can now easily access ILBs. Along with the recent listing of Commonwealth Government bonds on ASX, there are six listed TIBs with maturities ranging from 2015 to 2035. Each has an adjusted face value, which has been increasing over time with the quarterly CPI. The current level of the face value is not too important; it is the future increases that will provide the protection.
(Editor's note: Take the free online ASX course on Exchange-traded Australian Government Bonds to learn about the features, benefits and risks of this form of investment).
List of Government Bonds takes you to the range of Exchange-traded AGBs on ASX and provides much information, such as the coupon rate, the adjusted face value; market bid and ask prices, payment dates and, importantly, real yields on each bond.
The real yield for these ILBs increases with the time to maturity. This represents the basic notion that more time exposure equals more risk, even for the Commonwealth Government. However, if investors are indifferent on the time risk of the Commonwealth bonds then buying a longer-dated ILB will give a higher real yield.
Counterbalancing this is interest rate risk; if interest rates rise, the coupon rate is uncompetitive and the market price falls to realign the yield with the new level of rates.
Note however, in all cases, the purchased yield including inflation expectations is obtained. In a sense, an ILB does provide some interest rate protection, on the notion that if interest rates rise because of rising inflation, the higher inflation rate ratchets up the face value, capturing some of the rate rise.
Who ILBs suit
ILBs suit investors who rely on the income sourced from investments to live. They should be very concerned that their income is not eroded by inflation, especially if the current historically low level of interest rates ends.
Interest rate investors need to have a diversified portfolio that will cope with various future scenarios, a major one being the potential for inflation to rise, another possibility of rising interest rates. It is better to be prepared than to act afterwards.
Now more than ever, the tools exist for individual investors to create a diversified interest rate portfolio. Through ASX, investors can access bonds directly; government and corporate, fixed or floating-rate hybrids, inflation-linked bonds, and a range of ETFs representing various fixed-interest portfolios based on a range of underlying credit profiles.
Consult your adviser to construct a portfolio to suit your income needs under various scenarios, perhaps with reference to rising inflation, rather than risk a surprise on the nightly news.
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.
Exchange-traded Australian Government Bonds has useful information on this type of bond, and links to other ASX material.
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