Wednesday 16 January 2013 by FIIG Research Legacy

Indexed annuity bonds - "The next big thing"

The last six months of 2012 saw a significant rally in many of the bonds we trade to the point where we are now suggesting you sell some of those securities

The problem has been trying to locate the “next big thing” in a market where spreads have contracted. We think indexed annuity bonds will be greatly sought after in 2013 and we suggest you consider adding the securities to your portfolio. This article highlights some of the key strengths of the securities and suggests three current opportunities.

What are indexed annuity bonds?

In exchange for buying an indexed annuity bond (IAB) with an up-front, lump-sum payment, you then receive a cashflow comprising both principal and interest, until the maturity date of the bond. So in effect you are purchasing a ‘salary’; an attractive proposition for those in retirement.  These bonds are ‘annuity like’ but the payment is indexed to the Consumer Price Index. That means IABs also offer protection against inflation, so that if inflation grows over time, so too will your cashflows.

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.

What is also evident from the cashflows is that, as principal is returned throughout the life of the bond under the IAB, the investor gets a much higher quarterly payment or income than a capital indexed bond (CIB). This is a key for investors when deciding whether their investment needs are better suited to an IAB or the more traditional inflation CIB.  Investors looking for higher income (cashflow) may consider an IAB better suited to their investment needs, whilst investors looking for an inflation protected capital return at maturity may prefer a CIB.

An annuity is a series of regular future cashflows, due and payable to the investor in return for the purchase price paid. 

Another interesting point to note is that by investing in an IAB, your exposure to the issuer decreases over time, as your investment is being repaid on a regular basis.

Key IAB strengths

  • As an IAB is indexed to inflation, it will protect the purchasing power of your investment
  • Tradeable, just like other fixed income securities
  • Long terms to maturity which help lock in returns, especially in a low interest rate environment
  • Can add diversification to your portfolio as there are many well-known issuers
  • Paying real yields over and above inflation of CPI + 3%
  • Low minimum investments given some bonds have repaid significant principal
IABs available now

All of these issuers in Table 1 have current research available and we are working to build the number of IABs we can show as DirectBonds.

* Total return includes the CPI assumption of 2.50%

Table 1

Praeco, will be well-known to many of you, being the Department of Defence Headquarters development in Canberra. The Praeco IAB has a lower total value than the other two securities and that is because it has returned more capital to investors since its inception. This means there’s a low minimum investment of $36,264, possibly making it a more attractive alternative. It also has a much shorter eight years to maturity compared to the other two securities that have an additional 15 and 12 years to run, which could be considered an advantage or a disadvantage. 

JEM Southbank is the Southbank educational precinct in Brisbane. This security has 23 years to run and if you’re wanting a very long certain cashflow, this security with its higher real yield is attractive.

Civic Nexus Finance is a subsidiary of Industry Funds Management Infrastructure Fund and was formed to design and construct Melbourne’s Spencer Street Station. 

Other issuers

Other issuers include: Australian National University, Royal Women’s Hospital, MPC Funding (Melbourne Convention Centre), Progress Health, NSW Schools and Newcastle Hospital.