## IABs offer protection against inflationary pressures, making them a crucial allocation during times of high inflation, but also offering many other benefits too. Here we discuss how they work and why they’re considered a core portfolio holding.

**Background**

There are two main types of inflation-linked bonds in the Australian fixed income market: Capital Indexed Bonds (CIB) and Indexed Annuity Bonds (IAB). While both types of bonds provide inflation protection, they have distinctly different structures.

In this article, we focus solely on IABs and hope to dispel any misunderstandings about this unusual section of the market. IABs can sometimes be seen as complex because of their unique characteristics – which is unfortunate because the core principles of IABs are easy to understand and the benefits IABs provide can be significant.

**How they work**

Indexed Annuity Bonds are surprisingly simple on the surface. They pay the same amount per quarter, each quarter, for a set period of time – but adjusted upwards for inflation. The real purchasing power of the payment is the same each quarter, but the dollar value rises slowly.

The formula for how much money is paid out each quarter is easy to understand. Things get a little more complicated if you try to break down the total payment into an interest payment and a principal payment. However, even then, the situation is not too tricky as the concepts closely mirror a standard home mortgage.

**Starting with the easy parts: an annuity and an indexed annuity**

A nominal or regular annuity is a stream of payments that occur on a specified schedule. The stream of payments is the same each period regardless of changes to the market interest rates. It is important to understand that, unlike a bond, there is no large final payment and no specific division of cashflows into a return of principal and separate coupons. Instead, in a nominal annuity, the return of capital and the interest paid are combined into a single stream of periodic cash flows.

For example, an annuity might pay a constant AUD1,000 each quarter for 10 years. In this instance, there would be precisely 40 payments, each of AUD1,000, so AUD40,000 in total.

An indexed annuity has the same structure of repeated periodic payments, but the payments are of slowly increasing nominal values. Rather than a fixed dollar value, an indexed annuity pays a constant purchasing power. The dollar value of the payment moves up in line with the movements of inflation. This constant purchasing power is embodied in the value of the original “base payment”.

As inflation slowly increases over time, so too do the index annuity payments. The first might be AUD1,000, but the second could be AUD1,008, then the third AUD1,012 etc. – it depends on each quarterly inflation print. Once again, there is no final repayment the of principal in a lump sum. The quarterly payments are the only cash flows.

Indexed annuities generally have a “floor” which prevents the value of the payment from dropping at any point even if inflation is negative for a period of time.

Mathematically, IABs have the following formula for each payment:

**Quarterly payment = Max CPI / Original CPI x base payment**

Where Max CPI is the highest CPI index printed since the IAB began and original CPI is the CPI at the start of the bond.

**The more complicated part: Splitting the cashflow into principal and interest**

Although an indexed annuity bond works by indexing the total payment and doesn’t mathematically distinguish between coupon and principal, an investor might be curious to know how much of each payment represents interest and how much represents the return of principal. (The Tax Commissioner might also be interested – though note that FIIG does not provide tax advice.)

Let’s start by considering an inflation-free environment and separate the coupon from the principal there. An inflation-free environment is equivalent to a situation where inflation is set to 0% for the life of an indexed annuity. In such a case the base payment would be the total coupon payment each quarter and this would not change for the life of the investment. Figure 1 shows this scenario, with the total payment received (base payment) remaining constant. This inflation annuity with indexation set to zero is exactly the same as a nominal annuity.

However, if we treat the annuity as if it were a mortgage, we can see how the principal and interest segments are split up. This is shown in Figure 1, where the total payments are divided between principal and interest. As happens with a mortgage, at first the payments have large interest components, but as time passes and the principal is slowly paid off, the interest component falls. Notice that the quarterly payment does not change.

Figure 1:

*Source: FIIG Securities*

The first thing that happens as we introduce inflation indexation is that the overall total paid increases each quarter. To demonstrate how the cashflow on an IAB increases with inflation, we have applied an inflation assumption of 2.50% (light blue line) to the base payment (dark blue lines), per Figure 2.

Figure 2:

*Source: FIIG Securities*

Figure 2 shows the total payment, but the indexation applies to both the principal and interest components. This is shown in Figure 3.

Figure 3:

*Source: FIIG Securities*

**How IAB returns and pricing are calculated**

**Yields: Real and nominal yields**

An IAB has a known original
purchase price, a known base payment (it’s part of the bond’s initial
announcement), and a known number of payments. With this information, we can
calculate the internal rate of return if the inflation rate is assumed to be
zero. This internal rate of return is called the “real yield” since it is the
return before inflation is considered.

The nominal yield is the sum of
the real yield and whatever CPI turns out to be. If we are attempting to
predict the yield in advance, you have the following relationship:

**IAB nominal yield = real yield + CPI assumption**

To further illustrate this, Figure 4 shows a selection of IAB bonds along with their real and nominal yields, assuming a 2.50% inflation assumption.

Figure 4:

*Source: FIIG Securities*

While inflation at times will
spike, resulting in a better return via a higher cashflow, the inflation
assumption used should be an average over the life of the bond. For
illustrative purposes, FIIG typically uses 2.50%, which is the middle of the
Reserve Bank of Australia’s (RBA) target range. Another indication of forward-looking inflation is the breakeven rate, which is the difference between a fixed
rate and inflation-linked bond yields at similar tenors. At the time of writing,
the 10-year break-even inflation rate is 2.53%.

Figure 5 below shows the
domestic quarterly year-on-year (YoY) inflation since 1993. Although currently inflation
is very high, when you examine the period since the RBA began inflation
targeting, you’ll note the average is 2.56% (indicated by the dotted line),
which is close to the middle of the RBA’s target range.

Figure 5:

*Source: FIIG Securities, ABS*

**Capital Price**

Since an IAB pays back the
principal slowly over time, the bond’s capital price will also drop slowly over
time. Similar to most other bonds, IABs are issued at $100. However, in an IAB the
price slightly decreases following each quarterly payment to reflect the
principal that has been repaid.

A similar, but slightly
different, concept is the bond factor. An IAB’s bond factor shows the remaining
proportion of the original principal which still exists at this payment. This
begins at 1 and drops slowly to zero.

The key difference is that the
Capital price is measured in nominal terms and so can rise with inflation. The
bond factor is in real terms and so does not reflect inflation.

The bond factor will always drop
consistently, while the Capital price can move oddly if inflation proves
unexpectedly high.

The Capital price of the bond
can also change if the real interest rate changes. This means the Capital
price of the bond can deviate from the remaining principal in the bond. This is
the same as the way a fixed rate bond price can deviate from 100 over the
course of the bond.

The fact that the bond price can
deviate from the remaining principal suggests that we need a better definition
of “par value” for IABs. For a fixed rate bond that is sold at 100 and matures
at 100 the par value is always 100. For an IAB that slowly amortises to zero,
the par value must also slowly drop to zero.

The formula for the par value is
the value that the bond would trade at if the yield were the same as at issuance
but including the effect of subsequent inflation. Inflation is measured as the
ratio of the highest CPI since the bond launch to the original CPI. This ratio
is known as the indexation value.

Mathematically that is:

**(Bond factor x indexation value) x 100 = par value**

Recapping, we have the bond
factor which represents only the fall in principal and drops from 1 to zero. We
have the par value, which represents the drop in principal and the rise in CPI
but assumes no change in yield. The par value drops from 100 to zero. Finally,
we have the capital price, which represents the actual trading price of the
bond, which also drops from 100 to zero but might differ from the par value.

For illustrative purposes, we
will calculate the par value for the Royal Women’s Hospital IAB, which is
currently trading at a clean price of $73.582. The bond’s current indexation
value is 1.668781, and its current bond factor is 0.43535.

(0.43535 x
1.668781) x 100 = RWH IAB par value

(0.7265038)
x 100 = $72.650

From this, we can see that the current trading price of $73.582 is at a small premium to its indicative par value of $72.650.

**Solid portfolio holding**

While IABs offer protection
against rising inflation, they are also a core holding in a balanced portfolio given
their defensive nature and strong credit rating.

These bonds were typically
issued to finance key infrastructure projects, including schools, hospitals,
convention centres and law courts. The IAB approach makes the most sense when the construction
stage has been completed and is all in the less-risky operational phase where
cash flows are known and generally rising with inflation – at least in general
terms.

The projects receive fixed
payments that are not contingent on the amount of patronage/usage or
competition risk, but rather the quality and availability of the facilities
being managed. This improves the credit profile, reducing seasonal/cyclical
exposures.

Generally, these types of bonds
have an investment grade credit rating, and the revenue stream is typically
from the respective state or state department, which is also reflected in the
strong rating.

While some IAB bonds have a longer tenor, for example with maturity dates in 2033 and 2035, they have less duration risk compared to a fixed rate bond of the same tenor. This is because IAB bonds repay the principal over the life of the bond, rather than a lump sum repaid at maturity. This also reduces the credit risk, with a smaller amount remaining with the issuer until maturity.

**Conclusion**

While IAB bonds are sometimes
perceived as being complex for their unique features, they are not so
complicated once you know how to think about them. IABs pay a quarterly payment
that has its purchasing power preserved through indexation to inflation.
Because the cash flow is indexed to inflation, the yield includes an inflation
assumption. The par value needs to be calculated, but works in a similar way to
a mortgage, with each quarterly payment having both an interest and a principal
component.

We consider IABs to be a core portfolio holding for their non-cyclical nature, strong credit rating, and infrastructure exposure.

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