Tuesday 18 September 2018 by Asmita Kulkarni Education (basics)

Understanding inflation linked securities

Asmita Kulkarni discusses why inflation linked securities should be in every fixed income portfolio. These securities protect investors against inflationary pressures while maintaining a steadily growing income flow. Below is an explanation of how these bonds work and the investment options available to FIIG clients

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A fixed income portfolio should have a proportion of its funds invested in core investments that have steady income and provide capital protection. Inflation linked securities such as Indexed Annuity Bonds (IABs) and Capital Indexed Bonds (CIBs) are core investment securities.

Due to the scarcity of inflation linked securities on offer, we recommend clients invest in these securities when supply becomes available. On a relative value basis investment grade securities tend to trade well above the benchmark inflation linked government bond curve. Additionally, the real inflation adjusted yield on these securities is often higher than the yields offered by equivalent rated corporate bonds.

Background

CIBs and IABs offer inflation protection by keeping cashflow paid to investors in step with the rate of inflation. This is an important consideration for investors looking to protect their spending power against destructive inflation. Inflation can be a major risk for wealth erosion and depletion of savings in real terms.

In Australia, these securities are often issued by investment grade rated entities and offer long term inflation protection and an inflation linked income stream. The return for these securities is a margin, being the real yield above CPI. The real yield can then be added to an estimated forward looking inflation assumption to calculate the nominal return.

The real yield ensures that the bondholder is covered against any unexpected spike in inflation, as measured by the CPI. Key characteristics, including structural details of CIBs and IABs are set out below.

Capital Indexed Bonds

CIBs are similar in nature to most corporate bonds, in that they are structured as bullet securities that pay regular interest and repay principal in full at maturity. The primary difference between CIBs and regular corporate bonds, however is that the principal amount on which interest is received changes with inflation.

At maturity, investors receive the ballooned capital face value that has been indexed over the life of the security. Therefore, the final capital value is higher than the par value of $100 in an inflationary environment. For example, assuming an annual rate of inflation of 2.5% and a coupon rate of 5%, the face value of a bond issued with $100.00 nominal amount will increase to $102.50 at the end of year one and to $105.06 by the end of year two. Therefore, this bond will pay a coupon of $5 in year one, $5.13 in year two (coupon paid on $102.50 nominal value) and $5.25 in year three (coupon paid on $105.06 nominal value), and so on until maturity. The above is a very simplistic example as these bonds usually pay quarterly coupons and are also indexed on a quarterly basis following the CPI data release. However, it should give investors an understanding of the basic principles of these securities.

Due to their nature, CIBs are a great investment option for those in accumulation. Given CPI contributes to capital growth over time, CIBs are a perfect investment for those simultaneously building wealth and wanting inflation protection.. CIBs are also known as inflation indexed bonds or CPI bonds.

Indexed Annuity Bonds

IABs are annuity structures with periodic payments that include an interest and  principal component. The cashflow is adjusted quarterly for inflation.. Annuities pay a steady stream of principal and interest, such that the full amount of principal is repaid over the life of the annuity with no lump sum principal repayment at maturity.

A conventional non indexed annuity bond makes equal repayments over the life of the bond, whereas the annuity payments on IABs are indexed to inflation. The equal repayment amount, known as the base payment, is indexed to inflation, so that the value of the base payment remains constant in real inflation adjusted terms. While these securities are amortising bonds by nature, as the principal is returned to investors, the advantage is higher regular cashflow sought by retirees. Figure 1 below is of theoretical cashflow on an IAB with a base payment of $100 per quarter. If we assume an inflation rate of 2.5% pa, the cashflow received by investors grows substantially compared to  a non indexed annuity bond where inflation assumption is 0% pa. However, while the nominal impact is dramatic, the impact on real returns is zero. This is because the indexing merely returns nominal values to an amount that keeps pace with inflation.

IAB cashflow


Source: FIIG Securities
Figure 1

IABs allow investors to invest in assets with strong credit ratings without sacrificing income. These securities are popular with those in a drawdown phase, requiring high cashflows.

Benefits of inflation linked securities for issuers

• Issuers often have inflation linked revenues, so issuing these securities allows them to better manage their assets and liabilities

• Longer term funding

• Some issuers would prefer to pay regular principal and interest payments over the life of the loan agreement, especially for project financing or infrastructure financing 

Benefits of inflation linked securities for investors

• Inflation protection, which is a long term concern for all investors

• Regular, accreting cashflow

• In the case of IABs, regular principal repayment means these securities naturally derisk over time

• Exposure to highly rated corporates, typically with state backed, but not guaranteed cashflows

Conclusion

Inflation linked securities offer unique protection, an important consideration for building wealth and sustaining purchasing power. Due to the scarcity of inflation linked securities on offer, we recommend clients invest when supply becomes available.

FIIG clients can access CIBs and IABs issued by companies such as AGN, ALE and Sydney Airport, Royal Women’s Hospital, Australian National University and Plenary Justice to name a few. These securities have maturities ranging from five to seventeen years and yields in the range of CPI + 1.30% to CPI + 2.60%.

Please speak to your Relationship Manager, call  1800 01 01 81  or email the Investment Strategy Group at ISG@fiig.com.au to get a detailed list of securities on offer and to understand which securities might best suit your investment objectives.



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