In the global interest

PIMCO boss Bill Gross has cult status on global bond markets. So when he recently declared that "the cult of equity may be dying, but the cult of inflation may only have just begun", you could almost hear the market standing to attention.

As the European debt crisis grinds on and the US economy struggles to gain traction, speculation grows that Europe and the US may try to inflate their way out of trouble by printing money.

If that happens, Australia is not immune to the fallout.

For this reason, inflation-linked bonds are experiencing a surge in interest.

Vanguard and NAB-owned Antares Capital have launched bond funds and iShares has a new exchange-traded fund, all specialising in Australian government inflation-linked bonds.

"Inflation-linked bonds are the only direct hedge to inflation because they are linked to the CPI [consumer price index]," a research director at FIIG, Elizabeth Moran, says.

Investors traditionally rely on shares and property to outrun inflation, but their returns aren't directly linked.

What's more, the sluggish global economy indicates both could be set for a prolonged period of low growth.

Investors have reacted by switching into term deposits and fixed-interest bonds, but these would also suffer if inflation is let out of the bag.

The purchasing power of cash is eroded by inflation, so investors demand higher interest rates to compensate.

When this happens, money locked away in existing term deposits and fixed-interest securities decreases in value and bond prices fall.

Unlike classic fixed-interest bonds, the face value of an inflation-linked bond and the interest rate it pays are adjusted quarterly for inflation in line with the CPI. You can buy and sell the bonds on the open market, but if you hold them to maturity the issuer repays the inflation-adjusted face value.

Strong foreign demand for Australian government inflation-linked bonds means they are trading at a premium to face value (see table).

"Australian government issuances are one of the few remaining triple-A issues of debt in the world," the managing director of iShares, Mark Oliver, says.

By contrast, some high-quality corporate issues are trading at a discount because the market has been betting on low inflation continuing (see box, above).

If you think inflation is a risk, Moran says the discounts on some corporate bonds offer the potential to make a strong capital gain as well as reap the benefit of an income stream that is guaranteed to rise with inflation.

Investors need a minimum of $50,000 to buy bond issues direct, and unlisted managed funds often have a high minimum investment, with few exceptions. You need a minimum $20,000 to invest in the Aberdeen Inflation Linked Bond Fund and $10,000 for the Antares fund (or $1000 with a regular savings plan).

The simplest and cheapest exposure is the iShares UBS Government Inflation exchange-traded fund.

It can be bought and sold on the ASX in minimum lots of one unit, currently priced at about $1.05. Management fees are 0.26 per cent.

Oliver says the fund only invests in Australian government (not corporate) issues because they are the highest quality, as well as being the most liquid and tradeable.

How the bonds work

Inflation-linked bonds are issued locally by the federal and state governments and large companies.

Most have long-dated maturities suited to long-term investors as a hedge against inflation.

To explain how they work, the research director of FIIG Securities, Elizabeth Moran, uses the example of the Sydney Airport issue, which matures in 2030.

The bonds were originally issued at a face value of $100. By last week, a $100,000 parcel of bonds had a face value of $117,300 after taking into account quarterly adjustments for inflation.

If the bonds matured last week, that's what you would have been paid. But the market price last week was $89,204 (the capital value), a discount of $28,096.

But the bond price is only part of the total return. The coupon, or interest rate, on the bonds is 3.12 per cent. If you bought them last week, the running yield on the discounted purchase price was 4.1 per cent plus inflation.

Using estimated inflation of 2.5 per cent, the yield to maturity is estimated at 7.05 per cent.

Inflation-linked bonds are more expensive than fixed-interest bonds because the capital value and interest have the potential to rise over time. But if inflation falls, you are better off in a traditional fixed-interest bond.

With inflation at just 1.2 per cent at the end of June, there is limited downside risk but plenty of scope for a rise in the future.