Tuesday 10 June 2014 by Elizabeth Moran Education (basics)

Three types of bonds: Part 3 - Inflation linked bonds

This is the third and final article in this series. Combined, the articles explain that bonds are appropriate investments across all economic cycles

There are three different bonds that work best under different economic conditions:
  1. Fixed rate
  2. Floating rate
  3. Inflation linked

An inflation linked bond (ILB) is the only investment that provides a direct hedge against inflation and therefore should feature in most investment portfolios.

It is important to hold an allocation to all three bonds for protection, as investors can never be sure that interest rates will not move higher or lower or that inflation will spiral. However, the portfolio weighting may change depending on the investor’s view of interest rates.

There are two major types of inflation linked bonds:

  1. Capital indexed bonds (CIBs)
  2. Index annuity bonds (IABs)

The two types of bonds work in different ways and one may be more suitable to your goals than the other. We often find the CIBs are more suitable to investors in the accumulation phase as they are seeking to meet longer term expenses. However the IABs, which return both interest and principal quarterly, find favour with investors in retirement that need the ongoing cashflow.

Major issuance in Australia is through the Commonwealth government and state government programmes as well as a number of banks and corporations. The majority of these are structured using the capital indexed model, however there are a small number of government and particularly infrastructure private public partnership that use the index annuity bond model.

Two main types of inflation linked bonds

1. Capital index bond

The most common ILB is the CIB where variations in inflation during the life of the bond are added and subtracted to the capital price of the bond, which results in what is known as ‘the adjusted capital price’.

A simple example would be as follows:

If a CIB had three years until it matured and inflation was 3% per year for the three year period, the capital price would rise from $100 to $103 in year one, where the increase in inflation is recorded on a quarterly basis, so as to coincide with the CPI release date. Then, in year two the adjusted capital price would be $103 + $3.09 = $106.09 and in year three $106.09+ $3.18 = $109.27 (Note: All calculations are rounded to two decimal points). The issuer would therefore pay the bondholder $109.27 at the maturity of the bond.

Assuming that the coupon margin (interest rate) is 4% over CPI, this margin does not change throughout the life of the bond, but it is paid each quarter on the adjusted capital price. So, while the fixed rate does not change throughout the life of the bond, the effective cash income increases with the underlying increase in adjusted capital price and equally will fall during deflation. Alternatively, when expressed as an annual dollar figure, it would rise and in this case be $4.37 (that is 4% x $109.27) at the end of year three.

Hence, the investor receives income in two ways as illustrated in the following example:

  1. If inflation rises, so does the adjusted capital price. If inflation was 3% in year one, the index factor increases the value of the bond by 3% which the investor can either hold in the portfolio or “cash-in” by selling down a small part of the investment.
  2. The coupon return, which varies both depending on the adjusted capital price/value and like normal coupon margins is also dependent on the credit quality of the issuer. Australian government CIBs will, all else being equal, have low coupon margins whereas higher risk corporate issuers will offer higher coupon margins. There are CIBs available to satisfy a range of risk/reward appetites.

The total return per annum (p.a.) in this case would be the sum of the increase in adjusted capital price of 3%, plus the real yield (fixed coupon) of 4%; providing a total return of around 7% p.a. excluding compounding affects, for the first year. By the start of the second year, the principal value, as reflected in the adjusted capital price, would move up from $100.00 to $103.00, and the coupon would be 4% times the new adjusted capital price of $103.00 resulting in a cash coupon of $4.12. In other words, both principal and interest increase with inflation.

Issuers of CIBs in Australia include: The Australian Office of Financial Management on behalf of the Commonwealth Government, Queensland Treasury Corp, TCorp, Commonwealth Bank, Envestra, Praeco, Rabobank and Sydney Airport.

2. Indexed annuity bond

IABs return both principal and interest at each preset payment date over the life of the bond until the maturity date (instead of one lump sum at maturity like the CIB). This is an annuity but the annuity is ‘indexed’ to inflation.

Just like paying a mortgage loan back to a bank, IAB investors take on the role of the bank and loan money to the issuer of the bond. Investors can then expect interest and principal repayments from the IAB issuer over the life of the bond. In the absence of any indexation (inflation), each payment would be 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. Assuming that inflation is positive, there is a steady increase in the payments over the term to maturity.

IABs offer investors a cash stream that will increase with inflation, so are perfect for investors in retirement as well as investors seeking a known cashflow over time. The graph below compares the cashflow streams for CIBs and IABs. CIBs are shown as dark blue columns and the annuity payments of IABs are shown as the light blue columns.

Notice how the IAB has much larger, and more even cashflows, while the CIB cashflow grows over time but has one large payout at maturity.

cashflow comparison IAB CIB edited

Another interesting aspect of the IAB is that it tends to decrease the exposure of the investor to the issuer over time, as the issuer pays out principal over the term of the bond.

Issuers of IABs in Australia include: NSW Schools, Melbourne Convention Centre and Australian National University.

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