Inflation is a risk worth hedging against with offshore investors purchasing record volumes in US inflation linked bonds. We suggest three Aussie ILBs that can provide long term protection
As published in The Australian on 5 December 2017. 
Inflation has been low and off the radar for some time. But just last week, growing concern over higher inflation became evident in markets as offshore investors purchased US government inflation linked bonds, known as TIPS, in the third highest volume on record at USD1.2 billion ($1.6bn).
Investors who have shunned inflation protection now see fit to add it to portfolios.
Erosion of purchasing power is back in the minds of investors, and although no one expects a return to an era of wheelbarrows of bank notes being necessary to buy bread, many of us want an investment that can help protect against increased expenses. Just ask any Australian who has received a power bill recently.
In Australian inflation securities, the capital and the income of the bonds are linked to inflation. Each quarter that shows a positive inflation reading builds the capital value of the bond, representing the amount that must be repaid to you. Investors also get paid a fixed rate of interest income, but as that’s paid on the growing capital value of the bond, this income is linked to inflation as well.
The advantage of inflation bonds is the complete correlation to inflation and the potential upside if inflation spikes like it did in the early 1970s. Potentially, when many other asset values are falling fast, inflation linked bonds outperform and smooth overall portfolio returns. Historically, shares haven’t provided the protection that investors need.
During the last 40 years, inflation peaked at 17.6 per cent in the 1975 March quarter when the cash rate was close to 10 per cent. Some may have forgotten what the economy was like, I remember arguing that mortgage interest rates could move higher than 15 per cent, and they did climb higher. Imagine what high inflation and high interest rates would do to highly indebted Australian households.
The return of above five per cent inflation would cause a rapid rise in the prices of many goods. Investors, particularly those no longer employed would see the purchasing power of their funds diminish, likely leaving them in a much worse financial position than planned.
This is why inflation linked bonds deserve a place in portfolios.
However, the bonds are scarce and there hasn’t been an Australian corporate inflation linked bond issued in the past decade.
Let’s take a look at what is available, and remember the bonds are to provide long term protection so I’ll aim for a 2030 maturity date. Don’t be too concerned about the term, these bonds are tradeable.
The lowest risk Commonwealth government inflation linked bond pays the consumer price index (CPI) + 0.577 per cent a year for a 2030 maturity date. There is no credit risk in these bonds, they are a pure inflation play much the same as the US TIPS.
Queensland Treasury Corporation also has a 2030 maturity with a yield of CPI plus 1.189 per cent per annum. This is a good pick up for a very low risk bond and only slightly higher risk than the Commonwealth government issue.
Perennial favourite and a bond I mentioned in my previous column, Sydney Airport 2030 would still be my choice with a return of CPI plus 2.89 per cent per annum, performing exactly the same function as the government bonds, but the higher income is hard to beat.
There is another type of inflation linked bond, that returns principal and interest linked to inflation quarterly that would be a good choice for those investors in drawdown.
An example is the Civic Nexus bond, which raised funds to help construct the Southern Cross Railway Station in Melbourne, formerly Spencer Street. It’s a public private partnership where 70 per cent of the revenues come from the Victorian state government, the remainder from retail outlets, car parking, bus terminal access charges, locker hire and advertising.
This low risk bond pays CPI + 2.38 per cent per annum but has a slightly longer term, completely repaying investors by 2032. I really like these bonds that rely on cashflows from a very strong quality tenant that is Victoria, even though they are not guaranteed by the State.
While I’m not certain inflation is going to increase any time soon, there is increasing evidence that global growth is rising and anecdotal evidence that institutions are seeking inflation protection, sure signs that individual investors should take heed.