Smart Investor, Getting Started: December 2013

Smart Investor, December 2013

Most of us haven’t had to worry too much about inflation in the years since the global financial crisis. Neither has anyone else in the developed world: creating any kind of growth has been a much bigger concern. But Australia’s jump in quarterly headline inflation to 1.2% in the third quarter, up from 0.4% in the second, suggests that we perhaps ought to start paying attention to it once again.

Inflation has a big impact on the way we invest. If inflation is running at a very low level, say, 1%, then we are likely to find low-risk assets like cash and government bonds attractive since they will bring us a return that still outpaces that inflation rate. If inflation is at 5%, those investments are less attractive, and we are likely to want to try more high-margin products in order to get ahead, such as shares.

Rising inflation hits fixed interest investors. If you put $1,000 in a government bond with a 5% yield, then at the end of the year you would have $1,050. So far so good. But if inflation was also running at 5%, then you’ve only really come out flat: your purchasing power – what you get for your money – has stayed the same and you have made no return. If inflation rises further to 10%, you’ve actually come out behind in real terms.

However, getting out of bonds and into riskier shares isn’t the only answer to a rising inflation environment. (And, let’s be clear, the recent spike in third quarter inflation doesn’t put the Reserve Bank of Australia at risk of being unable to keep inflation within its targeted band of 2-3% annually, so there’s no need to make hasty decisions on this.)

One approach to the inflation headache is to buy inflation-linked bonds, sometimes called index bonds, or linkers. There are about $40 billion of these outstanding, the vast majority of them from the Commonwealth and state governments. There will be more to come. The author interviewed Rob Nicholl, CEO of the Australian Office of Financial Management in Canberra, earlier this year, and asked him about inflation-linked issuance from the commonwealth. “We have a broad mandate from the government to develop the inflation index part of our portfolio to 10 to 15% of outstanding,” he said. “We’re just below 10% now. We’ve gradually increased the amount of issuance in that market and our outlook is to develop it in a steady way. We’ve got support to do that.”

Inflation-linked bonds work like this. Like any other bond, you make an investment and receive a quarterly coupon payment, followed eventually by the principal when the bond matures. The difference with an inflation-linked bond is that the coupon depends on the rate of inflation, which you can determine by looking up the consumer price index, or CPI. That way, the theory goes, you are insulated from movements in inflation.

However they’re not entirely risk free, since they are exposed to movements in real interest rates. And in fact, so far this year inflation-linked bonds have performed miserably: down 4% by the end of September, according to Bank of America Merrill Lynch, which ranked 2013 the worst year for the asset class since it began studying it in 1997. But one could argue that makes it a cheap area to invest, with a lot of potential.

Inflation-linked bonds tend to suit the long-term investor. In September, for example, Australia sold A$2.1 billion of inflation-linked bonds with a 22-year maturity – much longer than anything available from regular Commonwealth bonds. That long duration appeals to investors like insurers who need to invest for the very long term and can’t afford to be surprised by inflation shocks along the way. That appeals to some individual investors too. For those who want a bit more return than the commonwealth offers, state government bonds tend to offer a bit more, and New South Wales and Victoria have been active issuers.

For most, inflation-linked bonds are just a part of an investor toolkit, something that can be used to add protection to a portfolio.

Box: Buying inflation-linked

Since May, investors have been able to buy Commonwealth inflation-linked bonds on the ASX. Five were listed at that time, with maturity dates of 2015, 2020, 2022, 2025 and 2030. They can by purchased in single units, each with a $100 face value.

Alternatively, investors can go for a fund. Aberdeen, for example, offers the Inflation Linked Bond Fund, saying: “inflation linked bonds are the only asset class to provider a low-risk real return over time, directly meeting the needs of those investors who require a reliable real income stream over the medium to long term.”

A fund like this gives us a useful illustration of how these assets perform. It is down 1.28% in the year to September 30, but up 7.66% a year over three years, and 6.18% over five years. (Those numbers are net of fees.) According to Morningstar, other inflation-linked funds are offered by Colonial First State, Macquarie, Mercer, Vanguard, Ardea and Ibbotson.

Some inflation-linked bonds are issued by corporations, offering higher returns for higher risk. Examples include Sydney Airport, ElectraNet and Envestra, although these are not, yet, available on the ASX and would instead need to be bought through a broker or within a managed fund.