Tuesday 03 November 2015 by FIIG Securities FIIG Securities Opinion

All-round inflation linked bonds protect no matter what

Inflation linked bonds can outperform when inflation is low or even negative. We explore what happens to investments and inflation linked bonds under three scenarios: 5% inflation, zero inflation and negative 5% inflation

The quarterly CPI figure was announced on 28 October at 0.5 per cent, equating to a low annualised rate of 1.5 per cent, but a low figure does not mean that investors can be complacent about inflation.

Although the headline CPI was low, the Reserve Bank uses a different inflation measure as its target – underlying inflation - and this rate was a more robust 2.1 per cent, although still within its 2 to 3 percent target range.

There is little imminent threat of an inflation blowout but history shows that inflation has a nasty habit of rearing its ugly head when you least expect it so investors must structure their portfolios to handle all scenarios.

In the March 1975 quarter, it hit a high of 17.6 per cent and for many years in the 70s and early 80s inflation was over 10 per cent per annum.

So, let’s explore a range of inflation outcomes and the impact they would have on your portfolio and inflation linked bonds.

First let’s assume inflation goes to 5 per cent per annum.

In this scenario, the economy is growing at a rapid rate and the prices of goods and services are spiralling. The cost to produce things is going up, so companies keep putting up prices. If you are an employee, your wages may be linked to inflation, helping you to cover higher costs. Retirees, on the other hand, more than likely have no hedge and many would find many consumables going up by more than they can afford. Power bills and health insurance are costs that come to mind.

Investors may benefit from rising property prices and rising share prices but they won’t rise in tandem and there is no guarantee they will actually do so. Inflation linked bonds provide the only direct 100 per cent hedge. The capital indexed inflation linked bonds add inflation to the capital value of the bond. While these bonds begin their journey with a $100 face value, this rises with inflation.

If we use the Sydney Airport bond that was first issued in September 2006 at a $100 face value as an example, after the latest CPI figure, its face value is now $125.86. This is the amount Sydney Airport now owes investors. While the maths behind the calculation is a little complex, if we assume quarterly inflation of 1.25 percent per quarter for the next year – 5 per cent in total – the capital price of the bond would rise to $132.27 in a years time.

Income was fixed at 3.12 per cent at first issue but is paid on the growing value of the bond. If you had bought the bond at $100 at first issue, the effective interest would have risen to 3.92 per cent per annum.

Next, let’s examine a zero inflation rate.

This is fairly easy to describe, as US and UK inflation are hovering around 0 per cent and the Japanese economy has been hovering around zero for many years. The number implies no or little economic growth, shares prices are stagnant, property may perform slightly better initially with low borrowing rates.

The Sydney Airport 2030 bond face value of $125.86 remains unchanged as there is no inflation flowing through to the face value of the bond. But investors still earn the fixed rate of interest on the bond, and at over 3 per cent per annum, it is an attractive investment compared to many others.

Finally, let’s assume inflation goes to negative 5 per cent per annum.

A negative annual inflation rate of 5 per cent is extreme and unlikely. It’s dire for investors as asset values spiral downwards. The value of the Sydney Airport bond would also decline but like other inflation linked bonds it has a safety net, where its value cannot fall below $100. Given the bond currently has a face value of $125.86 due to past inflation, that would still represent a large fall in value.

A negative 5 per cent inflation rate would cause the face value of the bond to fall to $119.68 over the next year. Even though the bond losses value, the fact that it is controlled and able to be calculated is a huge benefit. This reduction in value is also offset by the interest that continues to pay irrespective of the inflation rate.

If you were concerned about deflation and negative CPI, newly issued inflation linked bonds near their $100 initial face value would protect the capital value of your investment as they cannot fall below $100.

If inflation is positive inflation linked bonds will keep pace no matter how high inflation goes. If inflation is near zero, returns will be positive given the fixed rate of interest paid on the bond and even if inflation is negative, that fixed income will assist in keeping returns positive at a time when the value of other investments is falling fast.