Monday 21 September 2015 by Education (basics)

Inflation linked bonds – Capital indexed vs Indexed annuity

A common misconception among investors is that all inflation linked products provide essentially the same type of protection against inflation. However, there are important differences in the various securities and also in the requirements of individual investors

Some seek mainly to protect their income and some to protect the value of their capital. This article identifies the best strategies for investors using inflation linked bonds to achieve their personal goals.

The discussion will centre on the cashflows generated by the bonds with no accounting for market fluctuations or changes in the assumed rate of inflation. We assume inflation runs at 2.50%, being the mid-point of the Reserve Bank of Australia’s target.

My aim is to answer three key questions:

  1. How do Capital Indexed Bonds (CIBs) and Indexed Annuity Bonds (IABs) differ?
  2. What drives investment in inflation linked bonds?
  3. How can I choose what is right for me?

How do Capital Indexed Bonds (CIBs) and Indexed Annuity Bonds (IABs) differ?

The most common types of inflation linked bonds in the Australian market are Capital Indexed Bonds (CIBs) and Indexed Annuity Bonds (IABs). The nature of these products makes them more suitable for some strategies and less so for others. It is important that investors recognise their reasons for investing in these securities and choose the right strategy for that goal.

Capital Indexed Bonds (CIBs):  Capital Indexed Bonds generally pay a relatively low interest rate and incorporate the rate of inflation into the value of the principal so the principal grows with inflation. Interest is paid based on the indexed value of the principal, and at maturity the final indexed value of the principal is repaid to the investor. The effect of this is twofold:

  1. Interest increases each quarter by the rate of inflation, but is generally lower than other fixed income investments.
  2. The value of the principal increases each quarter by the rate of inflation, returning a greater amount of cash upon maturity or sale of the bond.

CIBs generally suit investors who are seeking maximum inflation protection for their capital and are particularly attractive when the bond is purchased at a discount to its indexed face value. The following two charts show the cashflows and value of the principal on the two Sydney Airport Capital Indexed Bonds with 2020 and 2030 maturities.

Assuming you invested approximately $100,000 in each bond, the projected cashflow and principal value is shown in Figure 1 below.

SydAir 2020/30 cashflow
 Figure 1

The comparative steepness in the two graphs (principal value) shows that the 2030 provides better protection, not just because it is longer dated but because it is trading at a discount to its indexed face value, further compounding the indexation effect on the principal value.

Indexed Annuity Bonds (IABs): Indexed Annuity Bonds have a predetermined paydown schedule, much like a mortgage, but with an additional factor in that each (quarterly) payment increases by the rate of inflation. This allows the inflation effect on the principal to be realised along the way, but leaves no principal value remaining at maturity.

IABs generally suit investors who are seeking greater inflation adjusted cashflows over the term of the bond, and those cashflows are greater for shorter term bonds (as with any other annuity). The following two charts show the cashflows and value of the principal on the short dated Praeco Indexed Annuity Bond (2020) and long dated Plenary Justice (PJS) Index Annuity Bond (2030).
 
 Praeco versus PJS
Figure 2

Assuming $100k is invested, Figure 2 shows that the shorter dated Praeco IAB generates much higher cashflow, but for a shorter term. Both securities are repaid over the life of the bond and there is no lump sum returned at maturity, rather just a final cashflow payment.

Contact your FIIG Representative for more information on Inflation Linked bonds.

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