Investors in Australian interest rate securities are likely to come across inflation-linked bonds but may not know what they are or how they differ to non-inflation-linked bonds. As part of its regular programme of issuance, the Australian Office of Financial Management (AOFM) routinely issues inflation linked government bonds. The following article aims to highlight the core things investors should know about inflation-linked bonds.
Inflation-linked bonds are securities that have been designed to give investors a level of protection from the effects of inflation, since inflation can substantially reduce the value of an investment. These instruments are generally issued by sovereign governments like Australia, the US, the UK through their state treasuries as a means of reducing their borrowing costs and broadening their investor bases. In Australia, both state governments and corporates have also been known to issue inflation linked bonds, indeed Tascorp issued such a bond in the third week of July this year.
Such bonds are indexed to inflation and this means that both the underlying principal and interest payments are free to move in line with the inflation rate. In an inflationary environment it can be very important for investors to focus on the real rate of return that they are seeing from their investments, which is a simple calculation that reduces the rate of return by the rate of inflation.
An example of this might be an investor who puts $100,000 in a one year term deposit that pays a return of 3.00 per cent while inflation is running at 2.50 per cent. The real rate of return on the deposit would be 0.50 per cent.
To overcome the value-reducing nature of inflation, inflation-linked bonds can protect investors by contractually linking the bond’s principal and interest payments to an index of the inflation rate, such as CPI: an increase in CPI translates into higher principal values.
In the case of Australia, the face value of Treasury Indexed Bonds is adjusted for movements in the CPI and coupon interest payments are made every three months, at a fixed coupon interest rate, on the adjusted capital value The adjusted capital value is also known as the nominal value of the bond. At maturity, the last coupon interest payment and the nominal value of the bond is paid to the investor.
In an environment in which there is deflation, where CPI drops, the nominal value of the investment falls. There is a floor on coupon interest payments which may protect holders of Treasury Indexed Bonds in an environment of deflation. If the nominal value falls below $100, the coupon interest payment will be paid on $100. If this happens, subsequent coupon interest payments and the maturity payment will be reduced by the difference between the coupon interest payment amount that was made and the payment that would have been made in the absence of the floor.
Treasury Indexed Bonds are not traded on an exchange and are typically traded in large parcels, which means that they will be beyond the reach of many retail investors. On the ASX, Treasury Indexed Bonds are traded in the form of CHESS Depositary Interests known as Exchange-traded Treasury Indexed (eTIBs). An eTIB Holder has beneficial ownership of Treasury Indexed Bonds in the form of CHESS Depositary Interests and this means obtaining the economic benefits attached to legal ownership of the Treasury Indexed Bonds over which the CHESS Depositary Interests have been issued. A one unit holding of an eTIB provides beneficial ownership of $100 Face Value of the Treasury Indexed Bond over which it has been issued.
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Paul McNamara is an editor and journalist with over 20 years’ experience. His career includes spells with the Financial Times, Euromoney, BRW Media, Asia-Inc and Banker Middle East. At present he is editor of YieldReport. YieldReport is a digital newsletter that carries comprehensive pricing and commentary on Australian interest rate securities in a monthly and weekly report. Each issue covers bank bills, cash accounts, term deposits, government bonds, semi-government and corporate bonds, hybrids, ETFs, managed funds and more. Click here for a free trial subscription. |
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