Inflation-friendly bonds

PORTFOLIO POINT: Buying inflation-linked bonds offers secure real returns that are immune from CPI rises.

Investors are increasing their allocation to bonds, either because they accept the notion of a “new normal” for returns or are simply seeking a tactical advantage. If this includes you, then perhaps you should consider incorporating inflation-linked income into your portfolio.

Inflation isn’t a problem now, although it is at the top end of the Reserve Bank’s 2–3% target range and if it continues to rise it could cause problems for the bulk of bondholders, who are locked into a fixed rate of return.

Conservative investors are by definition the most uncomfortable with stockmarket risk yet they inadvertently take on the most risk, hoping interest rates will compensate them for the ongoing decline in purchasing power of their paper money.

The aim of most investors is to preserve and grow their purchasing power, but the reality is that very few employ investments that are explicitly linked to same consumer price changes that threaten this goal.

While high-yielding savings accounts and term deposit do this in spades now, there is no guarantee this will always be the case. So here are just a few ways investors from all walks of life can mitigate those risks and introduce inflation-linked income to their portfolio.

Directly purchased Commonwealth government inflation-linked bonds

Possibly the safest and most defensive investment in Australia is the TI406 series (or similar) Australian Commonwealth government capital-indexed bond.

This AAA-rated inflation-linked bond will pay you income each quarter equal to 1% of the indexing face value of the bond, which increases quarterly with the CPI. This bond, carrying a 4% annual coupon, was issued 14 years ago at a notional face value of $100 and its indexed value is now $144.

If inflation averages just over 3% annually for the next 10 years, then when this bond matures on 20 August 2020 it will pay back $200 (the initial $100 adjusted to preserve loss of purchasing power since 1996). Along the way, the bond holder is treated to rising income as the coupon payment is applied to the indexing capital value.

What I also like about this class of bond is that if bought on issue and held until redemption, the income paid and capital returned is linked only to CPI and not to interest rates. This helps it play a complementary diversifying role in a defensive portfolio.

To buy this now, you may have to pay about $162, which makes the yield 2.5% before inflation indexing. The Commonwealth government has at least five inflation-linked bonds on offer, maturing in 2015, 2020, 2025; and launching just this week, one redeeming in 2030. The latter two issues pay reduced coupons of 3% and 2.5% respectively, perhaps reflecting the rising demand.

Individuals, but unfortunately not companies, trusts nor SMSFs, can buy these directly from the RBA Small Investor Bond Facility in amounts between $1000 and $250,000. You and your SMSF, however, can buy bonds directly through a bond broker. Brokers traditionally deal in minimums of $500,000 per bond to invest, but some may break popular bonds into more digestible $50,000 lots.

Inflation-linked bond funds and other directly purchased bonds

The federal government isn’t the only issuer of inflation-linked bonds. You may be surprised they are also issued by:

• Banks, such as the Commonwealth, ANZ, Rabobank and Westpac.
• State government authorities, such as the New South Wales Treasury, Queensland Investment Commission and Treasury Victoria.
• Large companies and infrastructure providers. These are natural issuers of inflation linked bonds as they expect to earn inflation linked income for years to come.

The credit worthiness of these issuers is less than the Commonwealth government which means you may earn 3–4% plus inflation indexing (versus about 2.5% on Commonwealth Bonds). Unfortunately this also means you need to hold a diversified bond portfolio to guard against default. As we are operating at the pointy institutional end of bond investing, where brokers trade bonds in minimum $500,000 lots, this means you may need at least $2–3 million to start building a portfolio.

For most people this isn’t possible and certainly not if they want to trim holdings to fund living costs or to rebalance their portfolios. This naturally calls for the use of an inflation-linked bond fund that manages a basket of many different bonds and related CPI investments on behalf of multiple investors. There are a small number of specialist funds with the oldest in Australia being that operated by Aberdeen.

More than 95% of their investing is done for large institutions including life insurance companies. Other funds are run by Challenger and Colonial (not surprising, since they are annuity suppliers and in the business of worrying about meeting inflation-linked promises), Macquarie Bank, UBS and recently Mercer. Some of these funds allow you to invest directly including perhaps for a minimum of $20,000. If you invest via a platform administration service, a few thousand dollars may be sufficient.

Others like PIMCO and Ibbotson run global funds that invest also in offshore bonds, which currently are yielding less. Part of the reason you haven’t heard a lot about these funds is because the supply of bonds is limited and few share my concerns about inflation-proofing investments and interest rate diversification.

To be fair to entering and exiting investors, the bonds in these funds are repriced daily. This means the unit price and short-term performance from these mostly long-duration bonds fluctuate – not because the return parameters change, but because the bond market is neurotically changing its mind what future inflation will be like and whether or not competing traditional, nominal interest-rate-linked bonds offer better or worse value. While the Inflation Linked Government Bond index returned about 11% for 2009-10, in the prior year it was about 0%, before that 6%. Since 1994 the index returned an annualised 7.8%.

Inflation linked term deposits: new and different

The Westpac Institutional Bank’s Structured Product division has just started offering investors inflation linked term deposits. They are like traditional term deposits in that they give you back your original non-indexed investment upon maturity, but the income paid varies with inflation.

Their “inflation linked deposit” pays a high initial headline rate of about 6%, say, for a five-year deposit. After each quarter this percentage is increased with quarterly inflation. For instance, if inflation was 1% for the quarter (4% rate for the year) then the next income payment will be based on an annualised rate of 6.06%.

The other product, “CPI Plus”, pays a lower fixed coupon of, say, 4% but also pays a second annual income payment based on the actual inflation for that year. If for instance, inflation broke out at 10% then you would get 4% plus 10% income that year (versus only 6.6% next year from their other product). The first product gives you a steadier and likely rising income, but arguably you aren’t as fully hedged to inflation. These products require a minimum $100,000 investment and are available for periods of one to 10 years.

Annuities – the new black?

Perhaps the second-safest investment in Australia is the old-fashioned annuity. For more than 100 years, life insurance companies have been providing a guaranteed inflation-linked income to “annuitants”, a name invented by actuaries to describe investors who sleep well at night not having to worry about share and property market returns and interest rates.

Annuities fell out of favour when the government stopped giving extra Centrelink benefits to those who agreed to surrender a portion of their assets in exchange for a long-term income (noting there are still some income-tested Centrelink and aged care benefits remaining). Annuity sales are growing again as investors apply two different strategies: first, to securely fund living expenses over the next two to five years, while share investments go on a longer-term journey of hoped-for growth; and second, to lock in a basic income for life with extra capital set aside for contingencies, giving and investing in riskier assets.

Challenger and CommInsure are the major annuity providers, both of which can provide you a guaranteed, inflation-indexing income for either a fixed term or for as long as you live. By way of illustration, for about a $1 million investment, a 60 year old male could buy about $55,000 of real annual income for his lifetime (the annual amount increasing with inflation).

For women this investment would buy an income stream of roughly $50,000 a year. Yes, this is discriminatory, but it is only because women are expected to live longer than men. I believe in other countries smokers and those with health issues can actually get a better rate! Expect to pay more or knock off about $5000 of first-year income if you want to retain the right to take some or all of your money back in the first 15 years.

Also, if you want the money to last for the longer of two lives (for a couple), you’ll need to pay more or live off a little less. I find these rates of combined income and capital return surprisingly good, given in an earlier article (see How much is enough?) I cautioned readers from drawing more than 5% of their nest egg in their first year of retirement.

If your tolerance to risk means you aren’t comfortable investing more than a third of your wealth in growth assets like shares, then you’ll probably struggle to outperform an annuity. This is possibly also true if you come from a family with long-life genes. Note investing in an annuity is a significant decision and you should seek out an expert to help you understands these products before you commit.

In the financial services industry, many make inflated promises. Inflation-linked bonds, funds, deposits and annuities are more likely to meet these promises if you worry about inflation or don’t want to tie too much of your defensive strategy to fluctuating interest rates.

Doug Turek is principal adviser of personal advisory firm Professional Wealth Pty Ltd. Products referred to here are for example only and their mention should not be treated as an investment recommendation or endorsement. Please conduct your own research or speak to a licensed financial adviser before investing.