Anyone with health insurance or paying private school fees will appreciate that prices increase every year and often by far more than inflation. The prices of certain other goods and services may decline in any given quarter, but overall there has only been one negative quarterly inflation rate in the last 25 years, making inflation a critical consideration when investing.
For the June 2015 quarter, inflation increased 0.7 per cent taking the annual rate to 2.3 per cent – very close to the rate for one year term deposits.
This raises the question of how best to combat inflation when interest rates on deposits are so low? To some extent, shares and property will help fight it but not necessarily keep pace with it.
The only direct hedge is inflation linked bonds. The returns you earn move in line with the Consumer Price Index. So if inflation were to spike as it did in the 1970s to over 10 per cent, your returns would include that 10 per cent base rate plus a margin.
There are two types of inflation linked bonds. Here are my picks:
1. Sydney Airport capital indexed bond, maturing in 2030
This bond was first issued in 2006 with a face value of $100. Every quarter, the capital value of the bond has risen by the headline CPI rate, so that its capital value today is $125.33. That is the amount Sydney Airport would have to repay if the bond matured today.
Interest payments on the bond are fixed at 3.26 per cent but they are calculated on the growing face value of the bond, so they also rise with inflation.
These types of bonds are ideal for SMSFs in accumulation phase as they protect against inflation over the longer term. There are a number of other attractive features about the Sydney Airport 2030 bond:
It is currently trading at a discount to face value meaning you would only have to pay $120.12 to purchase $125.33 of value
The yield to maturity (calculated on a 2.5 per cent inflation assumption) is a high 5.97 per cent per annum
It is rated as investment grade by the credit rating agencies
2. Melbourne Convention Centre indexed annuity bond maturing in 2033
This bond was issued by MPC Funding Ltd (MPC), which is the funding arm for the Public Private Partnership that developed the Melbourne Convention Centre. While the building is now complete, the Public Private Partnership continues to provide cleaning and maintenance to the centre. A whopping 98 per cent of its revenues come from a quarterly payment from the State of Victoria.
The bond works like a mortgage in reverse where investors pay an up-front lump sum and it is returned to them in principal and interest payments – linked to inflation, over a specified period. For example, if you invested $100,000, your first quarterly payment would be $1,767 and, assuming 2.5 per cent inflation per annum, this would rise to $2,784 for your final payment in 2033. The expected yield to maturity is 5.07 per cent per annum.
This type of inflation linked bond is better suited to investors in retirement seeking an inflation adjusted income.
One last thought. Investing about $100,000 in each of these bonds would deliver an annual cashflow of about $10,300 for the next 15 years until the Sydney Airport bond matures, delivering an anticipated lump sum of $147,000. The Melbourne Convention Centre would still make quarterly payments for a further three years. The estimated total cashflow given $200,000 initially invested is $371,000.
Both of these bonds are only available in the over-the-counter market. All investors can buy the Sydney Airport bonds but the Melbourne Convention Centre is only available to wholesale investors. There are similar indexed annuity bonds available for retail investors.
