Tuesday 14 June 2016 by Jonathan Sheridan Opinion

Break even inflation and fixed rate bond comparisons explain why we still like ILBs

A number of events have occurred in the Australian market over the last month or so. It’s crucial for investors to understand the potential risks and rewards – we discuss some market insights and alternative bond options 

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RBA rate cut

The RBA proved they watch inflation data very closely, as they cut rates as soon as we had the soft Q1 inflation print a few weeks ago.  What was interesting to observe was the follow up Minutes of the decision, which demonstrated that the decision was more finely balanced than previously alluded to, with some argument for waiting.

Glenn Stevens then announced that the RBA would not abandon their 2 to 3% inflation target, which is encouraging as it implies the RBA will be watching closely and cutting if they see further inflation weakness.

We are likely to see another one or two cuts this year, especially if the upcoming inflation numbers continue to be soft.  On 18 May we had the weakest wage growth number on record, which doesn’t bode well for higher inflation in the short to medium term.

The AUD has retraced nearly all of its 2016 run up, from 0.6864 on 16 January, currently sitting at 0.7225, down from a high of 0.7805 on the 19 April.  Potential further rate cuts and a rate hike from the US Fed could see this trajectory continue downwards.

Budget

The budget threw up a huge curveball for SMSF trustees, with new limits imposed for untaxed assets and income.  The affirmation of property as the favoured asset class for Australia was quite clear, with negative gearing on the agenda but neither party opting to discuss it in detail yet.

We’ll be bringing SMSF Association specialist adviser Tony Negline to the table in next week to explain these super changes and what they will mean.

Of course, the new budget isn’t law yet, but it is clear that super is in the sights of both parties to generate more tax revenue as spending isn’t going down anytime soon.

The bond market in general

Since the start of the year we have seen a large rally in commodity prices, which has been beneficial for Australia in general.  At the same time, we have seen the US’ rate rise expectations be almost completely removed from market pricing, and as a result local rates have declined considerably. The effects of these rate shifts are shown in lower inflation and record low wages growth, as well as a dearth of non bank corporate issuance.

We are in the middle of a huge rally in credit, as we have seen with the performance of many bonds – notably Glencore 2019 and Adani Abbot Point 2020. 

We advise to take profits where they are available, and try to pick up cheap bonds which are likely to rally.  In general the rally has been confined to high quality investment grade (IG) credits, but will no doubt spill over to lower rated, higher yielding credits as value disappears in the IG space.

Inflation

Given the focus we have placed on this sector of the bond universe in the last few years, it is important to distribute our thoughts on why we continue to like this area, particularly in the face of the first negative inflation print in nearly a decade.

There’s some technical stuff at the start so stay with me…

Break even inflation

Our models use a 2.5% inflation assumption as the mid point of the RBA’s target band, over the life of the bonds.  Generally the bonds themselves are relatively long dated, so we deem this an appropriate – albeit conservative – assumption, as inflation has averaged about 3% over the last decade.

However, the market uses a bit more of a dynamic measure, which attempts to incorporate up to date information and reflect the ever changing expectations of the market.  This is called break even inflation, or BEI.

BEI is defined as the difference between a government fixed rate (nominal) bond and the yield on the equivalent maturity government inflation linked bond (“linker”) – the rationale being that the linker will increase by inflation but the nominal does not. So, the difference in the yields to make the investor ambivalent in owning either must be the break even rate of inflation.

As of 14 June 2016 the Australian 10 year government bond yield looks like this, with the nominal bond in white and the linker in yellow:


Source: Bloomberg

Bloomberg also shows BEI for a range of maturities:

But how is it relevant to current inflation linked bonds?  Let’s apply BEI to the Sydney Airport bonds, two of which are inflation linked, long dated and considered strong investments as inflation pricing is low. They have also recently issued a 10 year fixed rate bond, which is convenient!

Because the fixed rate bond is USD denominated, a tactic which the issuer and many institutions often do is swap the USD cashflows back into AUD using a derivative, which pays the holder the equivalent cash in AUD.

Doing this we get the following results, with real yield being the return over inflation:


Real yield YTM assuming BEI YTM assuming 2.5%
SYDAIR-ILB-3.76%-20Nov20 2.95% 4.46% 5.45%
SYDAIR-3.625%-28Apr26-USD 2.67% 4.36% 4.36%
SYDAIR-ILB-3.12%-20Nov30 3.54% 5.33% 6.04%
  2026 swapped back to AUD minus BEI  Real yield + BEI for linkers
2026 swapped back to AUD
 Real yield + 2.5% for linkers
2026 swapped back to AUD


We can see that even using the now conservative BEI price in the market, the Sydney Airport 2020 offers a higher yield to maturity of 0.10% more than the 10 year fixed rate bond, for a six year shorter exposure
.  The 2030 linker with an extra four year exposure gives a 0.97% higher return, over the fixed rate bond. But the generic BBB curve prices a 10 to 15 year exposure at 0.30%, so you gain 0.67% more than the generic BBB rated bond for the same tenor extension.

If you believe over the longer term that inflation is likely to average 2.5%, then the pick up is 1.68%.

I think this is compelling evidence as to why we continue to favour inflation linked bonds, and in particular in preference to similarly rated and tenor fixed rate bonds.

Please contact your FIIG representative for further details on the Sydney Airport bonds, available to both retail and wholesale investors in minimum parcels of $10,000.

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