We continue to see considerable value, both on a pure risk/reward basis and on a portfolio diversification basis in inflation linked bonds (ILBs)
This article looks at what is available for investors in ILBs for both capital indexed bonds and inflation indexed annuities. We also show how they differ which may help you decide which is more appropriate for your needs. There are two types of inflation linked bonds (ILBs) in the Australian bond market: the capital indexed bond (CIB) and the inflation indexed annuity (IIA). Both bonds offer investors protection against inflation as their cashflows are linked to an inflation index (most commonly the Consumer Price Index - CPI).
What is available in ILBs?
Many of our investors are already familiar with some of our favourite issuers of ‘CIB’ inflation linked bonds (Sydney Airport and Envestra), so I will not discuss these in detail here, and you can of course look on our website for our latest research on these two credits.
Inflation indexed annuities may however be new to many of you, but the names of the issuers should be familiar (see Table 1). As I noted last week, the annuity style bonds effectively amortise over the life of the bond, that is, they pay back the principal amount (in addition to interest) over the life of the bond, so at maturity, there is $0 remaining in outstanding principal. For this reason, annuity style bonds are well suited to assets which have a finite life, this way the value of the debt does not outstrip the value of the asset at maturity.
As our investors are familiar with Sydney Airport and Envestra, they are also familiar with some of the Public-Private Partnership (PPP) bond issuers like Praeco Pty Ltd (the Department of Defence headquarters), JEM (Southbank) Pty Ltd (the TAFE education facilities at Southbank, Brisbane), and RWH Finance Pty Ltd (the Royal Women’s Hospital in Melbourne). Like Sydney Airport and Envestra, we have research available on these names on our website as well.
Table 1
As part of the capital structure of these PPPs, they have each issued an IIA, which helps pay down the principal amount owed over the life of the asset. Remembering that these PPPs are effectively a series of government backed cashflows with a definite contract date end, you can effectively say that the asset value at the contract end is $0. In turn, it is appropriate that the debt value at this time would also be $0. As such, these structures require their debt profiles to amortise over the life of the contract. The IIAs help the issuer achieve this.
The IIAs from these issuers are all ranked senior secured, so rank pari passu with the other senior secured bonds from these issuers, and as such pricing reflects similar spreads to their other senior debt – though adjusted for the longer tenor. If you are interested in any of these IIAs, please contact your FIIG Dealer and they can provide you with the detailed cashflows on a quarter-by-quarter basis for each issue (as it is impractical to include quarterly cashflows for a 20 year bond in this article).
Capital indexed bonds
As the title suggests, CIBs have their capital, or the principal amount of the bond outstanding, indexed (usually quarterly), with the revised indexed capital amount due for repayment at maturity. If you had a bond with a one year maturity (bought for $100) and inflation increased at 3% for the year, you would have capital of $103 returned at the end of that year.
As the indexation increases the principal value of the security over time, the amount due at maturity becomes greater, so your capital is protected against the perils of inflation. The indexation process results in part of the periodic return being effectively capitalised into the outstanding principal. The interest on the bond is payable on the higher indexed capital amount, at a fixed coupon rate, so, if the above example was paying interest of 5% (assuming just one annual interest payment for this simple example rather than the normal quarterly interest payments), the 5% interest would be based on the $103 capital value (or $5.15) rather than the initial $100 investment.
Note: The capitalised value of the bond can reduce in periods of deflation, although this has only happened in eight quarters out of the last 169 (42 years) in Australia. Also there is in-built protection in most CIBs that the minimum capital returned to investors at maturity is the original $100 face value.
Inflation indexed annuities
With inflation indexed annuities (IIAs) the investor receives a cashflow comprising both principal and interest, until the maturity date (that is the principal is repaid over the life of the bond rather than in one lump sum at maturity). This is an annuity, but the annuity is ‘indexed’.
The principal repayment schedule is calculated in essentially the same way as a conventional house mortgage. In the absence of positive indexation (inflation), each payment would be equal, consisting of part principal and part interest. This amount is also referred to as the base payment or ‘base annuity’. The base payments are indexed (by inflation) over the life of the asset, resulting in a steady increase of payments over the term to maturity.
As an annuity, IIAs offer a higher annual cash return to investors, but no return of capital at maturity (again, as the capital is returned over the life of the bond).
CIB v IIA: key differences explained
The key difference between the two assets is the tenor of the investment. As the investor has to wait until maturity to receive the full capital value back under the CIB, its tenor will be longer than the IIA, which returns the capital gradually. The investors’ capital is at risk (or deployed) for longer under the CIB.
We have worked a cash flow comparison of CIBs and IIAs in our detailed research paper, which you can read by clicking here.
In our examples (shown in Table 2), investors pay $1m for each asset, and both yield 7.56% (quarterly), each with maturity dates of 29/10/2016. In reality CIBS and IIAs have much longer terms to maturity, but it’s much easier to show a four year cashflow than a 20 year cashflow. The CIB principal remains outstanding until the maturity date, whilst the IIA principal is returned progressively throughout the term to maturity, the IIA has a shorter tenor and subsequently a lower total cash return.
Cashflow comparison CIBs vs IIAs
Table 2
The reason the total cash return is higher in the CIB is that you are being rewarded for having your capital outstanding for longer.
What is also evident from the cashflows is that, as principal is returned throughout the life of the bond under the IIA, the investor gets a much higher quarterly payment or income. This is a key for investors when deciding whether their investment needs are better suited to a CIB or an IIA. Investors looking for higher income (cashflow) may consider an IIA better suited to their investment needs, whilst investors looking for an inflation protected capital return at maturity may prefer a CIB.
Regardless of which type of ILB you wish to invest in, they currently offer a good opportunity to diversify your portfolio and gain protection against long term inflation.