Inflation-proof investments for Australian investors

Conventional inflation-linked bonds are not the only option for retail investors.

Summary: The cost of living in Australia will rise as our dollar weakens, and that will further erode returns from fixed interest investments. Inflation-linked bonds will provide a hedge against this, but don’t’ overlook corporate bonds and even some ordinary shares that can serve the same purpose.
Key take-out: Higher inflation rates could push interest-bearing security investments into negative territory.
Key beneficiaries: General investors. Category: Fixed interest.

Many years ago I can remember experiencing negative interest rates as inflation was between 5 and 10%, and interest rates struggled to match that level.

And, with personal tax rates as high as 60%, interest-bearing securities were really not a very good alternative because they offered negative interest rates – i.e. you lost purchasing power every year. With low inflation we have had positive interest rates in recent years, and deposit investors have all come to like it.

But now that’s changing because Australian management has not invested sufficiently in productivity (but rather outsourced production and services offshore), and we have not undertaken any efficiencies in the public service. That means that if the dollar falls our inflation rate will rise, assuming there is no management revolution in the public service.

Australia now has an inflation rate that is running at around 2.6% to 2.7%. The base Reserve Bank cash rate is 2.5%, so we are in negative territory on the base rate. Individuals in superannuation funds via term deposits can get 3% or 4% on their money and, with a 15% tax rate, they usually are still in positive territory – just.

But individuals may be taxed up to 47%, and unless they are on very low incomes individuals they are certainly not in positive territory – they are experiencing a negative interest rate, which means if inflation holds or increases each year the value of bank deposit money will decline.

The Australian inflation rate will come down when the carbon tax is eliminated, but the underlying problem is that we are more dependent on imports of services and goods. So if the American dollar rises as the Federal Reserve Bank begins to reduce its bonds buying program in its tapering exercise (I expect it will) and the Australian dollar falls, then our cost structures will rise. Of course, in the government area, there has been absolutely no consciousness of costs.

So far both parties have concentrated on slashing programs instead of looking at the abundant ways to improve public service productivity. That means that investors in interest-bearing securities are now beginning to cop it on the chin, particularly as older people have cost of living levels that are higher than the CPI.

It is not easy to counter. I have a small portion of my portfolio specifically allocated to inflation hedge investments. It has not been a runaway success compared to normal share investments. I differentiate the inflation hedge from simple share investments and various long deposit investments taken out at higher rates.

Corporate bonds

The way I have structured that is to have inflation bonds that are linked to inflation. Government bonds that are inflation linked have not performed well, but I did not use them. Rather, I invested in corporate bonds issued by Envestra and Sydney Airport that are effectively inflation-linked bonds.

In essence, the bonds have a low coupon rate but the principal rises with inflation, so there is a substantial payment on maturity. There is a minimum investment. Envestra and Sydney Airport are two companies that have these sorts of securities. But there are others.

An infrastructure hedge

Separately, I have been able to find an ordinary share that effectively offers something very close to inflation-linked bonds. Toll roads are excellent because their income is relatively stable and linked to inflation. So my holding in Transurban is part of my inflation strategy.

Until now, investing with a view to hedging against inflation seemed a stupid thing to do because there has in fact been almost no inflation. But times are changing, at least in Australia. And so while I expect inflation to decline on the back of the carbon tax, the base problems remain.

Until we increase our productivity and do something about the costs in the public service, we are going to have inflation rates that could push interest-bearing security investments into negative returns or certainly close to negative returns.