PORTFOLIO POINT: Inflation-linked bonds offer both protection from inflation and a good margin in a low interest rate environment.
Lessons from the US: Inflation-linked bonds offer more than protection from inflation.
Global government stimulus aimed at increasing growth (and inflation) in the economy is leading to fear about the possibility of a spike in inflation. In recent times the RBA has kept inflation within its target 2-3% band but some of you will remember the run-away 1970s where inflation topped 17% and the mid-1980s where it was close to 10%.
What happens to investors’ portfolios if this occurs again? How do they mitigate against this risk?
The only direct hedge against inflation is inflation-linked bonds (ILBs). These bonds are tied to the Consumer Price Index (CPI) and their capital value grows with inflation, so that over time the capital value increases. The coupon must then be paid on the higher capital value, so it too increases over time, assuming inflation is positive. ILBs are issued by the Commonwealth government, some Australian states and corporations. While it is true equities and property may to a degree hedge against inflation, there is no certainty. Equally we’d expect floating-rate notes, whose coupon payment is tied to the bank bill swap rate (BBSW) to offset inflation through changes to BBSW; but there’s no guarantee it would mirror a steep rise in inflation.
Investors at or near retirement should have an allocation to this very special security to give them peace of mind in terms of maintaining purchasing power when they’re no longer working.
The US experience, as outlined below, highlights the effectiveness of a high known real yield (over and above inflation) in a low-growth scenario.
In the US, things are tough and Figure 1 below shows just how low the yields are on US Treasuries. From 2009, investing in short-dated investments has led to low returns and uncertain future returns. The long-dated nominal or fixed-rate bonds have offered the best returns, although these are only around 2%. I don’t think any of us would consider these returns acceptable for our portfolios.
However, investors need to consider inflation and Figure 2 shows the performance of US government floating investments (Fed Funds) and fixed, relative to inflation. Yields for the floating-rate securities have been less than zero since 2010 once inflation is deducted, and while the nominal (fixed-rate) bonds have performed better; neither investment has protected investors sufficiently from inflation.
In other words, the US gives us some insight as to what happens in a low-growth, moderate-inflation environment. Not that Australia is destined to follow the US experience; yet analysing the largest, most developed market, helps us to understand the implications of a low-growth environment and ways we can protect our portfolios should that scenario develop. Now, if we add inflation to the ILB returns, the picture is much more supportive of the ILB, as Figure 3 shows below.
Figure 3 shows that government ILBs still deliver adequate returns when inflation remains moderate in a low-growth environment.
Recent experience suggests that ILBs have outperformed nominal bonds, although the critical point remains what interest-rate spread, above government, investors’ receive. Here, we can estimate what a US investor might receive if they obtained the same spread above government that they receive in Australia, say 4.50% for a corporate ILB such as Envestra, above the government, or more.
Even in the case of the US, where rates are very low, the theoretical corporate ILB still shows value and the achievement of reasonable returns. However, to consider this in more detail, we now turn to the Australian experience.
Australian ILBs – value is still apparent
While government yields have also fallen dramatically, just like the US, as Figure 5 shows, there are still opportunities in the semi-government ILB market (remember all yields in Figure 5 are quoted over and above inflation, so that the Queensland Treasury Corporation 2030 ILB is offering a yield of inflation plus 2.25%, the equivalent to 4.75% based on inflation of 2.5%).
Table 1 shows some of the current ILB opportunities. All of the securities listed with the exception of the Rabobank ILB are available to retail investors, in minimum face value parcels of $50,000, although the table uses $100,000 parcels so that it is easier to see how the face value of these securities has risen over time with inflation.
Note: The Rabobank ILB is only available to wholesale investors in minimum $500,000 parcels, but this is a very low-risk senior bond with a real yield of 3.21%, which is very attractive given the very low-risk involved.
It’s important to note that the Commonwealth government and the two state government ILBs are all trading at a premium to face value. That is the total value is higher than the face value. However, the four corporate ILBs are all trading at a discount to face value, offering the potential for capital gain if held to maturity.
If we take the Envestra ILB as an example, and this is one of my particular favourites (I’ll explain why I like the credit in a moment), reading across the table, it has a maturity date of 2025, so is very long-dated and particularly attractive to those in or near retirement. Its coupon, set at issue, was 3.04%, however with the current discount to face value you pay $102,749 for bonds worth $121,430 (the current face value the company would have to pay you if the ILB matured today), the real yield or current real yield to maturity is higher than at first issue and is a high 4.65%. Our investment model then assumes inflation at 2.50% to provide an estimated yield to maturity of 7.15%. Now that’s outstanding value and over that magical 7% where you can expect to double the value of your investment in 10 years if you compound the interest.
Now for a bit more about why I like the Envestra ILB. Many of you will know about the company’s gas distribution networks. But did you know the company’s financial profile has improved over the last two years? Envestra has paid down short-term debt with the aid of equity injections and lowered dividend payments, which is all very supportive of bondholders sitting higher in the capital structure. What makes the ILBs even more attractive is the fact they are “wrapped” or insured by Assured Guaranty, a more highly rated entity, which boosts the overall credit worthiness and lowers the risk of these particular ILBs.
What happens if we enter a deflationary environment?
In a deflationary environment the face value of the ILB reduces accordingly. This means that the interest you would expect to earn from the bond is revised down based on the revised lower face value of the bond. However, most ILBs have a floor stating “$100” as the minimum face value that must be returned to the investor.
Also, it’s worth noting that there has only been one period of deflation in Australia in the last 25 years.
In a deflationary environment most investments would perform poorly, yet the lower interest rates that could be expected in such an environment would mean that these securities would be lower in yield and higher in price compared to current valuations.
Earning a good spread, when your investment is in a senior position in the capital structure, is one of the key take-aways from the US. If a 4%-5% real return remains attractive, then corporate ILBs represent an excellent opportunity. Even if inflation falls to zero, you can still earn a defined spread above inflation, which is in the 4% to 5% range.
While the market has competed away returns in US treasury yields, and Australian Commonwealth government ILBs, value is left in the semi-government ILBs, as well as the corporate ILBs. The Envestra 2025 ILB remains one of my favourites.
Note: All prices and yields are a guide only and 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.