Indexed annuity bonds and SMSFs

Summary: Investors looking for reliable cash flow and inflation hedge could consider an indexed annuity bond.

Key take-out: The bonds act like annuities and although there is no lifetime cover, they have a maturity date.

Three of the biggest problems faced by self-managed super funds in drawdown are: building a reliable cash flow, making sure money lasts, and protecting against inflation.

I think indexed annuity bonds provide an ideal solution to all three of these significant problems and more.

Let me explain. Indexed annuity bonds have been issued by public private partnerships or joint ventures to help fund the construction and maintenance of important infrastructure projects such as schools, universities, hospitals, railway stations, government buildings and even water treatment plants.

The bonds were issued some years ago in the over-the-counter bond market and are very much long-term in nature. The entities typically receive payments from the State or Federal government, making them low-risk investments.

An index annuity bond works like a reverse mortgage. Investors pay a lump sum up front which is then returned over the life of the bond in quarterly payments which include both a principal and interest component. These periodic payments are increased each quarter to reflect inflation, which is particularly valuable to retirees wanting steady income with added inflation protection. The value of your investment is paid down over the life of the bond. The bonds act like annuities and although there is no lifetime cover, they have a maturity date.

Importantly, they can also be used in estate planning and left to beneficiaries in your will.

One very well-known example is Australian National University (ANU). In 2004, ANU issued a $115 million indexed annuity bond, maturing on October 7, 2029, to fund growing capital expenditure (including re-development of the John Curtin School of Medical Research and renovation of the Research School of Physical Sciences and Engineering).

Like other bonds, it was issued with a $100 face value, but it has been repaying principal since 2004 and the current principal outstanding – which includes the effect of inflation since 2004 – is around $78. A new investor needs to pay more; approximately $84, as these bonds have become sought after for their high yields given very low risk. The current projected yield to maturity on these bonds is 4.28 per cent per annum, which includes a 2.5 per cent per annum inflation assumption.

Let's assume an investor starts with an $84,000 investment today. The bond would pay its first full quarterly payment in October and return $2,055, then $2,068 in January 2019, $2,081 in April and $2,094 in July.

Notice how the payment is increasing. This is because our model assumes positive inflation at the mid-point of the RBA target range, which is 2.5 per cent per annum. Lower inflation would mean lower payments and higher inflation means higher payments. Payments would continue until October 2029, when the last payment, projected at $2,704, would be paid.

In total, 45 payments would be made over an 11-year timespan, providing a reliable cash flow to the SMSF. The bonds would also provide an inflation hedge and return capital, so would therefore assist in meeting minimum withdrawal amounts from the SMSF in drawdown. Magic!

Young retirees might look at longer dated options such as JEM Southbank maturing in 2035, a wholly owned special purpose finance vehicle majority owned by funds managed by AMP. The original finance was used for the construction and operation of the Southbank Education and Training Precinct for the State Government of Queensland under a private public partnership. This bond has a projected yield to maturity of 4.93 per cent per annum.

Investors thinking about a portfolio of these bonds could also look to add Civic Nexus, where funding was used to construct Southern Cross railway station in Melbourne; Novacare, which was contracted by the NSW Department of Health for the financing, design, construction and refurbishment of various facilities at the Mater Hospital in Newcastle; and Jem Schools, the financing vehicle contracted to finance, design, construct, maintain and manage 11 schools in NSW.

We have access to 16 indexed annuity bonds, around half of which are available to retail investors. We haven't seen any new issuance for some time, which is a great shame as these bonds are perfect for SMSF retirees. Like other bonds, they can be bought and sold in the secondary market. I think they make great low-risk, stable additions to any portfolio and present good relative value.