Key points:
- FIIG’s model that estimates returns on inflation linked bonds assumes inflation at 2.5%
- Higher inflation means the quoted yields on your inflation linked bonds may be higher than when you first purchased them
- Seven of the top ten bonds performing bonds for the last financial year were inflation linked bonds
Last week, headline inflation for the quarter ending June 2014 was announced, taking annual headline inflation to 3%, the upper stated tolerance for the Reserve Bank. This was good news for investors in inflation linked bonds.
FIIG’s model that estimates returns on inflation linked bonds assumes inflation at 2.5%, the Reserve Bank of Australia target mid-point. Higher inflation means the quoted yields on your inflation linked bonds may be higher than when you first purchased them.
If you hold capital indexed bonds the capital price of the bond will be increasing at a faster rate than the model predicted, providing higher returns to investors.
Last week, we detailed our best performing bonds for the last financial year. Seven of the top ten bonds were inflation linked. To read that article, please click here. Below is a brief description of inflation linked bonds.
Most investors have savings but fail to insure those savings against the threat of inflation. ILBs are the only product linked to the CPI which provides a direct hedge against inflation. Floating rate notes (FRNs) offer some protection against inflation as the coupon, which is tied to a benchmark (usually BBSW) is adjusted quarterly.
Investors need to remember that the cost of living rises with inflation. When expenses rise, ILBs keep pace with the increase while savings held in a bank account do not. Importantly, the benefit of ILBs as an instrument for meeting future streams of inflation linked expenses tends to increase in proportion to time, because inflation regularly erodes the spending power of savings and the cashflows of fixed rate bonds, which do not increase based on inflation.
There are two main types of ILBs in Australia:
- Capital indexed bond
- Inflation indexed annuity
Capital indexed bond (CIB)
The most common form of inflation linked bond is the capital indexed bond (CIB) where variations in inflation during the life of the bond are added to and subtracted from the capital price of the bond, which results in the adjusted capital price.
A simple example would be as follows:
If a CIB had three years until maturity and inflation was 2.5% per year for the three year period, the capital price would rise from $100 to $102.50 in year one (where the increase in inflation is recorded on a quarterly basis to coincide with the Consumer Price Index (CPI) release date). Then, in year two the adjusted capital price would be $102.50 x (1 + 2.5%) = $105.0625 and in year three $105.0625 x (1 + 2.5%) = $107.69 (rounded to two decimal points).
The issuer would therefore pay the bondholder $107.69 at maturity.
Coupons (interest) would be based on the new adjusted capital price. If the coupon in this example was 4% p.a., that remains fixed throughout the life of the bond and is paid each quarter on the adjusted capital price.
So, your effective cash income increases with the underlying increase in adjusted capital price and equally will fall during deflation. Alternatively, when expressed as an annualised percentage of the initial capital value of the transaction, the income would rise, and in this case be 4.3076% p.a. by the end of year three (i.e. $107.69 x 4% = $4.3076 ÷ $100 initial capital value = 4.3076%).
Hence, the investor receives income in two ways as illustrated:
- If inflation rises, so does the adjusted capital price. If inflation was 2.5% in year one, the index factor increases the value of the bond by 2.5%
- Fixed coupon (interest) return on an increasing adjusted capital value. In the example above 4.0% p.a.
The total return per annum (p.a.) in this case would be the sum of the increase in adjusted capital price of around 2.5%, plus the real yield (or fixed coupon) of 4%; providing a total return of around 6.5% p.a. excluding compounding effects.
The coupon varies depending on the credit quality of the issuer and the time of issuance. Australian government ILBs will, all else being equal, have low coupon margins whereas higher risk corporate issuers will offer higher coupon margins. There are ILBs available to satisfy a range of risk and reward appetites.
Some issuers of CIBs include: Sydney Airports, Envestra, New South Wales Treasury Corporation and the Commonwealth government.
Inflation indexed annuity
Indexed Annuity Bonds (IABs) are another type of inflation linked bond, but unlike a CIB, return both principal and interest at each preset payment date over the life of the bond. IABs have these annuity payments ‘indexed’ to inflation. The majority of the CIB’s cashflows is repaid to investors at maturity where as the IABs release cashflow over the life of the bond, meaning an IAB is well suited to retiree needs.
The principal repayment schedule is calculated in essentially the same way as a conventional mortgage; that is, in the absence of inflation, each payment is equal, consisting of part principal and part interest. This amount is also referred to as the base payment or base annuity. The base payments are indexed by inflation over the life of the bond, resulting in a steady increase of payments over the term, assuming inflation is positive.
Some issuers of IABs include: JEM (Southbank Tafe), Melbourne Convention Centre and Civic Nexus.
This article also appeared in The Australian.
