A bomb-proof bond portfolio for 2013

With inflation likely to rise, it’s sensible to take steps now to protect your portfolio.

Summary: As well as insuring against inflation, the returns offered by inflation-linked bonds over the Consumer Price Index may meet your broader investment criteria. Residential mortgage-backed securities also are trading at good relative values.
Key take-out: Many inflation-linked bonds are trading at a discount to their face values, which means you are paying less than the bond’s current value.
Key beneficiaries: General investors. Category: Portfolio management.

In my last column The top bond picks I outlined the excellent returns made in the bond market last year. It’s unlikely we’ll see those very high returns this year, but any hiccups in the global growth story could well see a return to a “risk-off” market away from high-risk equities and back towards capital stable, lower-risk and lower volatility bonds.

High returns are always attractive, but bonds (even in a low interest rate environment) should have a permanent place in any portfolio.

Whatever the scenario, I’m a firm believer that there are always opportunities in any asset class, whatever the economic environment. In this note, I want to focus on what your goals are for your portfolio. Do you remember the goals you set out when you established your self-managed superannuation fund? In many cases I know investors often seek to beat a benchmark, and one of the more common benchmarks is inflation. The reason inflation is used is because it can erode the purchasing power of your savings.

Globally, governments have committed to stimulate their economies by keeping interest rates low. Domestic interest rates are at a low point and some commentators think they will move lower. Adam Carr in his article Is the inflation genie stirring? expressed his concerns regarding rising inflation. I agree with his sentiment that inflation shouldn’t be discounted; low interest rate stimulus is creating the perfect stage for an inflation outbreak. My question to you then is, have you got enough protection should inflation spike? Also, what’s your target return over inflation?

My Eureka model portfolio holds two inflation-linked bonds; the Sydney Airport 2020 and Envestra 2025. Combined they account for roughly 14% of the portfolio. Depending on your inflation view and your dependency on your investments to live, I’d recommend you hold anywhere between 10% and 30% of inflation-linked bonds (ILBs) in your portfolio. The lower fixed rates fall, the greater your allocation to inflation-linked bonds should be. As I’ve mentioned in other articles, you should also be starting to add floating-rate notes (FRNs). In other words, plan for an inflationary/rising interest rate environment.

ILBs are an investment that will give you certainty in regard to beating inflation. That is because income is linked to the Consumer Price Index (CPI), and if the CPI increases so do your income payments and, in the case of capital-indexed bonds, the amount the issuer must repay you at maturity. These are excellent investments for investors approaching retirement and wanting to make sure their investments keep pace with inflation (see previous articles A bond that’s licensed to kill, inflation and Getting the inflation drift for more information). Table 1 below shows a range of capital-indexed inflation-linked bonds.

There is a good range of risk and returns in this table. All the bonds are senior debt, so sit high in the capital structure. The face value amount shown is the value of the investment you are buying and if maturity was the same day, the amount the company must repay you. If the capital value is less, then the bonds are trading at a discount, providing a capital gain if you hold to maturity.

The coupon is the interest payment over and above inflation, set out at first issue. However if you look at the running yield this is the interest margin based on the current price of the bond and does not include any inflation assumption. Running yield will increase as the capital value grows. The yield to maturity returns are based on an inflation assumption of 2.5% (the RBA target mid-point).

For investors with large amounts to invest, the Commonwealth Bank 2020 ILB with an estimated yield to maturity of 4.85% looks attractive, especially given very low and fixed term deposit rates and the flexibility of the bond given interest payments will grow with inflation, coupled with very high liquidity.

Inflation-linked bonds for retirees

If you are already in pension mode, the capital-indexed bonds mentioned above may not be the best option for you. Waiting until maturity for the return of the majority of your funds may not suit. Another type of inflation-linked bond called the indexed annuity bond (IAB) might be more appropriate. Investors outlay a lump sum when they buy the bonds, then the issuer returns the capital plus interest (which is the part linked to inflation via the CPI) over the life of the bond. Table 2 shows a range of IAB issues.

The (refinance) risk with these bonds declines over the life of the bond as you are being repaid principal. The most attractive IAB here is from Australian National University; essentially you are buying a bond, the majority of whose revenue comes from the Federal government, and are being paid an estimated 5.48% return. If you’re a retail investor the Praeco IAB is attractive in that Praeco has no other debt repayment due before 2020, so it is highly likely this bond will be repaid on time and in full.

Why buy inflation-linked bonds?

The sceptics in the audience will be asking, “why buy these bonds when inflation is low?”  There are a couple of good reasons:

  1. Buying any investment counter-cyclically is a key investment strategy. Waiting until the market signals increasing inflation will mean you miss the full benefit and could mean you purchase at the top of the market, perhaps over-paying for the investment.
  2. Many inflation-linked bonds are trading at a discount to their face values, which means you are paying less than the bond’s current value.
  3. In a low interest rate environment the margin you can earn over the CPI in itself can be very attractive. In some cases this is approaching 4%. Remember, if CPI is at or below zero returns on all of your other investments are likely to be very, very low or negative.

Residential mortgage-backed securities – good relative value

Residential mortgage-backed securities (RMBS) are a very good investment if you can source them. They are typically very low risk and highly rated (in the AAA or AA range) as they are secured by a pool of residential mortgages. The higher-risk properties often have mortgage insurance and a growing equity base. From time to time we see sellers in the secondary market and the margins can be very attractive. Just a few weeks ago a parcel of ME Bank RMBS came onto the market with a yield to maturity of over 7%. The securities didn’t last long but if you think these types of investments might interest you, talk to your broker and get them to register you as an interested buyer when the next securities become available.

Take profit on higher-risk securities

Those big returns on bonds last year mean most existing bond investors had a very good year. Like any investment, if you think it’s had its run, take some profit and invest in something else; like the inflation-linked bonds mentioned above.

All prices and yields are accurate as at 31 January 2013 and are a guide only, subject to market availability. FIIG does not make a market in these securities.

Elizabeth Moran is director of education and fixed income research at FIIG Securities.

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