Four ways to fight inflation

Inflation is on the agenda, wiping out cash returns and leading to negative returns. Savings rates and term deposit rates have fallen close to, or even below, the recent inflation rate of 2.90%. Below I have chosen four ways to protect your capital and spending power from inflation. These include listed securities trading on the ASX and annuities, which are easily accessible.

Protecting your portfolio from inflation can be expensive, due to the lower rates of return or lower yields that can be associated with products specifically targeting inflation. But there are other options that do not directly target inflation that can provide some protection, and may even provide a higher relative return.

Low real returns from interest receipts

The impact of inflation is more likely to be felt by those in retirement phase that are living off income from their investments. Retirees are more likely spending a greater amount on expenses that are more closely aligned to inflationary increases, such as a health, utilities and food.

Despite the outlook for inflation being relatively stable, there will be a continuous inflationary impact on income from investments, due to ongoing low interest rates.

There are a few ways to manage inflation, which for retirees in particular will be useful in offsetting inflation’s negative impact on income, including:

1. Floating-Rate Notes
2. Fixed Rate Bonds
3. Exchange-Traded Treasury Indexed Bonds
4. Indexed Annuities

1. Floating-Rate Notes (and Hybrid Securities)

The benefits of buying securities that pay a coupon based on a margin over the bank bill swap rate (BBSW) is that, as interest rates move up (with higher inflation), so will the coupon (the coupon is based on the security’s issue margin plus the BBSW divided by the price of the security). The coupon is usually reset semi-annually or quarterly, moving in line with changes to the BBSW. Floating-rate notes can be bought on the ASX (see table 1).

Listed hybrid securities, which I have discussed previously, (see “Hybrids: higher yielding but higher risk”), also pay a floating-rate return. Hybrids have been sought after by investors, as they pay a higher relative yield to other interest paying securities.

The announcement of the next Commonwealth Bank hybrids issue, which I featured last week (“Queuing for the next PERLS issue”) is likely to be in demand with investors. This is despite the $2 billion size of the issue being unprecedented and the pricing (the margin above the BBSW) towards the lower end of previous issues in the market. The selling point, for CBA’s new issue, is likely to be the more favourable yield compared to other hybrids trading in the market. The rally in prices of currently trading hybrid securities has compressed yields.

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2. Fixed Rate Bonds (and Term Deposits)

Fixed rate bonds can offer some protection against inflation. Although the interest rate is fixed at the time of issue of the bond and does not change when interest rates change, reinvestment of interest payments can offset some of the inflationary impact.

ASX-listed fixed rate bonds are predominantly Treasury Bonds or TBs (table 2) and have been available for trading since December 2012.

The inflation benefits of a fixed rate bond are from the reinvestment of a proportion of the interest payment. The compounding effect prevents the erosion of the real balances of interest payments; compared to if it was withdrawn every year as income.

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For an investment of $100,000 earning 4% interest per annum, 2.5% can be reinvested (assuming inflation of around 2.5%) and the balance of the interest payment (1.5%) can be withdrawn as income.

After 10 years the annual interest payment has increased to $4,995 as a result of the compounding effect from the reinvestment. If there was no reinvestment, the annual interest payment would remain at $4,000 for the 10-year period. The end of year portfolio value after 10 years would also be higher for the strategy that reinvested a portion of the interest, at $128,000 compared to $100,000.

This strategy can be replicated using term deposits, reinvesting some of the interest payment paid at the end of the term, and rolling the subsequent higher capital value into another term deposit.

3. Exchange-Traded Treasury Indexed Bonds

Exchange-Traded Treasury Indexed Bonds (TIBs) have been trading on the ASX for the last 18 months (table 3). TIBs are a relatively new type of security available to retail investors, and as a result the liquidity in the market is lower relative to other securities. TIBs provide inflation protection as coupon interest payments are based on the adjusted nominal value, which increases in line with changes in the CPI.

The pricing of inflation-linked securities is based on a certain inflation assumption, which has recently been around 2.5%. If inflation is 2.5% in the future, then the performance of fixed rate bonds and TIBS will be about the same for similar maturity. However, if inflation jumps unexpectedly to 4.0% over the next few years, then TIBS will adjust the nominal value to reflect this unexpected jump. Fixed rate bonds will not adjust the capital value, leading to outperformance from TIBS relative to the fixed rate bonds. If the opposite happens, and inflation is only 1.0% in the future, then TIBS will underperform fixed rate bonds.

The face value of a TIB at issue is $100 and increases with inflation until maturity of the bond. Coupon interest is paid quarterly and is a fixed percentage of the adjusted nominal value.

So for a TIB with a coupon of 3% and an adjusted nominal value of $108.35, the coupon payment will be $0.813 (3.00 ÷ 4 x (108.35/100). If the nominal value increased with inflation to 109.38, the coupon payment per TIB will be $0.820 (3.00 ÷ 4 x (109.38/100) = $0.820). The payments will continue every three months until maturity, when the nominal value (as adjusted for movement in the CPI over the life of the TIB) is returned.

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4. Indexed Annuities

To help offset the impact of inflation on the purchasing power of the regular payments from an annuity, most providers of annuities offer the choice of indexation (see my previous article about annuities, Annuities: Worth exploring). This provides some relief from changes in the Consumer Price Index (CPI) by increasing the regular payments by the amount of the increase in CPI.

Particularly beneficial to those in retirement phase who require a steady stream of income, that maintains its purchasing power in the face of inflation.

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How much inflation protection is optimal?

One of the drawbacks of protecting the spending power of your income and capital balances from inflation, with inflation-linked securities, can be the lower yield or rate of returns from the securities compared to other asset classes.

But the benefits are not just protection from inflation. The price performance of inflation-linked securities is often different to shares, property and fixed rate bonds, which may provide some protection in times of market volatility.

The amount of a portfolio to hedge is dependent on the risk/return objectives of the investors. An investor in retirement is more risk adverse, and also more exposed to the inflationary impact on the spending power of their income.