Published in The Australian 18 April 2015
The bond market is a good predictor of financial market conditions, so it’s worth watching even if you are not an investor
The bond market is a good predictor of financial market conditions, so it’s worth watching even if you are not an investor. This week, the Australian Office of Financial Management sold $200 million of government inflation-linked bonds maturing in November 2018 at a real yield below zero. The real yield is the return above inflation.
This was an Australian first, although hardly unprecedented in other parts of the world where such figures have become common. The deal signals investors want inflation protection, are prepared to pay for it and consider the bonds good value compared with other similarly rated investments. To put it another way, the outcome of the auction signals the market expects inflation to lift beyond the 1.7 per cent annual rate we saw in the fourth quarter of 2014.
When bonds are first issued, investors are asked to tender a bid. For the recent issue the AOFM received bids of $925m, more than 4.5 times what it hoped to raise. The bid included the price investors would pay for the bonds, which all showed negative real yields, the highest one being negative 0.015 per cent and the lowest negative 0.085 per cent. While the real yield on the bonds is negative as long as inflation — as measured by the Consumer Price Index — is higher than the negative yield, the overall return would be positive.
While the negative real yield on the government bonds will deter individual investors, there are a number of corporate inflation-linked bonds with attractive returns to hedge against inflation. Some margins over CPI are close to term deposit rates, in effect giving investors a free hedge.
Anyone making plans for the future would benefit from an allocation to inflation-linked bonds. The bonds ensure the purchasing power of your money keeps up with inflation.
This is important for retirees. They don’t have the protection of a salary — likely to increase with inflation — but consume a greater proportion of inflation-linked goods and services, such as healthcare and power, as a percentage of income than workers.
ALE Property Trust, which owns a portfolio of more than 80 pubs, has a low-risk inflation linked bond. The trust is 25 per cent owned by Woolworths, while the remainder is owned by Mathieson Group. The bond is expected to mature in 2023; the yield is now 1.65 per cent plus CPI.
If you assume CPI is 2.5 per cent, the midpoint in the Reserve Bank’s target inflation range, the predicted yield to maturity in 2023 is 4.15 per cent a year.
Another low-risk option is from Envestra, now part of Australian Gas Networks. The bond is credit wrapped, meaning if Envestra can’t pay income or principal at maturity, an insurer pays it instead. This enabled Envestra to get a higher credit rating on the bond, making it cheaper to raise the funds at first issue. The bond matures in 2025 and yields 1.8 per cent over CPI. With a 2.5 per cent inflation assumption, yield to maturity is 4.30 per cent a year.
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