Wednesday 28 November 2012 by Kieran Quaine Legacy

The perfect security - An aged based investment strategy

The perfect security is a combination of two types of inflation linked bonds: a capital indexed bond while investors are still working and accumulating superannuation funds then an investment in an inflation linked annuity when you hit retirement

A simple yet very effective way to build capital pre retirement is to invest in Capital Indexed Bonds (CIBs), which have a low coupon (interest) distribution but a high real yield (the yield earned in excess of inflation) and their capital value increases with inflation.

A very effective way to meet pension and reinvestment requirements in the post retirement phase is to invest in Inflation Linked Annuities (IIAs), because IIAs repay both principal and interest regularly; they have high cashflow.

By making a few realistic assumptions, best explained directly by your FIIG sales representative, we can show you how you can achieve a desired pension outcome by investing in a CIB and then selling it at the point of retirement (or buying a CIB that matures near retirement date) and investing the proceeds into the IIA. We assume you can purchase the IIA at the same real yield as what is available today.

Because the CIB and the IIA prices are both linked to inflation, the CIB will provide a (near) perfect hedge for the change in price of the IIA (that is prices of both bonds should move in a similar fashion). So, whatever changes there are to inflation they will be reflected through the Consumer Price Index. Assuming the companies remain solvent, you are protected and will receive that inflation adjusted pension!

See the link below for an actual cashflow example that will help you to understand the strategy. Our example shows only two securities for the sake of simplicity. It comprises one CIB and, upon maturity, one IIA.

 

Example investor and investment requirement:

  1. Investor is currently aged 57 and has an intended retirement age of 65
  2. Estimates that if they were to retire today they would require an income of $64,000p.a. ($16,000 per quarter) indexed to grow with inflation
  3. Given a CPI assumption of 2.61% per annum (average CPI since 1992), our investor will need approximately $79,000p.a. income from 2020, if that is when they wish to retire

Let’s round that number up to $80,000 p.a. or $20,000 per quarter, again, indexed to grow with inflation. We will revert to a 2.50% assumption for the rest of the analysis (middle of the RBA target range).

 

Example investment strategy to meet investment requirement:

Question: Given current asset prices, how much capital does this investor need to invest NOW, to achieve the $80,000 cashflow in eight years’ time?

While the answer is dependent on life expectancy, let’s say our investor lives to 80, chosen because the 15 year IIA, that will be invested in, in 8 years’ time, is the longest available IIA currently issued in the Australian market place.

Answer to the question: Given the assumption of CPI at 2.50% (and a few other assumptions) the answer is $566,850.

An investment of $566,850 will buy $460,000 Notional Face Value (FV) Sydney Airport 2020 CIBs, at a real yield of 4.00% (total yield of 6.50% with CPI estimated at 2.50%). This FV is currently index to an adjusted FV of $580,360 which will have a maturing estimated value on 20/11/2020 of $704,000. Additionally, if the coupons that are paid by this bond are reinvested at the assumed reinvestment rate of the current bank bill rate as derived from the interest rate swap curve, they will compound to a value of $199,500 on 20/11/2020.

The subsequent total value of assets held at the completion of the capital accumulation phase, pre the commencement of the pension phase, is $903,500.

This amount will buy $960,660 Notional FV of the JEM Southbank June 2035 IIA at a real yield of 3.80% (total yield of 6.30% with CPI at 2.50%), providing the investor with 15 years of quarterly payments of $20,000 each, indexed to CPI.

Importantly, it does not matter what inflation is, as the investments will appreciate in line with inflation, thus providing the required $64,000 pension (original requirement in today’s terms).

Note that the figures in the model were prepared before the coupon payment was due). Also note that these figures do not consider taxation.

 

Conclusion

The combined strategy of buying a CIB now, then at maturity or point of retirement buying an IIA protects your capital against inflation and provides a steady income in retirement.  

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