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 Inflation-linked bonds need just one ingredient - Eureka Report article 

Inflation-linked bonds need just one ingredient

By Scott Francis
May 6, 2009

PORTFOLIO POINT: Inflation-linked bonds, likely in the budget, might not be as exciting an opportunity as the concept suggests.

There will be many interesting aspects to the federal budget, not least the possibility of the government issuing inflation-linked bonds targeted at retail investors.

This is potentially an option attractive to investors concerned that low interest rates and worldwide government stimulus packages might lead to an outbreak of inflation, a scenario that none less than Warren Buffett has advised investors to be wary of.

Although there is - as yet - very little information in the market, advisers and commentators are already telling investors to take up these inflation-linked bonds.

Investors are also been told to hold off rushing into existing bonds aimed at the retail market because, after all, what could beat a government guaranteed inflation-linked offering?

But for most investors the information is too far ahead of the curve: the majority of retail investors are still trying to figure out what bonds are, how they can be accessed in Australia and what an inflation linked bond might look like.

Traditionally bonds are issued by either governments or companies (corporate bonds) as a way of raising money to fund activities. The government or company offers a regular series of interest payments to the bond holder, as well as the return of their money at a set date. The regular series of interest payments are usually made on a six-monthly basis (semi-annually).

Bonds have traditionally been rated by Standard & Poor's, Moody's or Fitch. These rating agencies provide a judgment on the creditworthiness of the bond. For example, a bond rated AAA by Standard & Poor's is the highest rating, and is equal to the rating given to the Australian government. The next highest is AA, which is assigned to the Big Four Australian banks. It then moves down to A and then BBB. Anything below BBB is non-investment grade or speculative (ie, junk bonds).

nInvestment grade
Fitch Moody's Standard & Poor's
AAA Aaa AAA Highest credit quality
AA Aa AA High credit quality
A A A Good credit quality
BBB Baa BBB Moderate credit quality


nNon-investment grade
Fitch Moody's Standard & Poor's
BB Ba BB Speculative
B B B Highly speculative
CCC Caa CCC High default risk
CC Ca CC High default risk
C   C High default risk
DDD C D Default
DD     Default


Source: ASIC

Bonds in Australia have tended to be sold with a value of $500,000 each - making them less accessible to average investors. Because of this many investors in Australia access bonds through managed funds, which give them the diversification they need within a portfolio. This comes at a cost, and active managed funds that charge fees of more than 1% eat into the potential fund returns.

Companies have moved to provide more bond-like investments listed on the ASX. These investments often include credit ratings, a set term until maturity and the promise of regular interest repayments.

Many banks have issued such debt instruments on the ASX recently, including hybrid notes such as Westpac (WBCPA) and Suncorp-Metway (SUNPB). Investors can purchase these investments using the stock code just as they would any other listed investment.

There have also been recent moves within corporate Australia to issue retail bonds with higher debt ranking than most hybrids. The recent issue of Tabcorp Bonds, for example, raised a total of $285 million, of which $85 million came from retail investors.

It is important for investors in bond type investments to be aware that:

  • Bonds can increase or decrease in value - especially as interest rates change.
  • Bonds can default, meaning investors will not receive all of their ?promised' return.

Put simply, bonds are not a risk-free option. They have a degree of capital volatility and are exposed to the financial risk of the issuer of the bond failing.

In Australia, those bonds listed on the ASX are corporate (company issued) bonds. The Reserve Bank also offers a Commonwealth Government Bond Facility for Small Investors (click here), offering bonds in multiples of $1000, with a $1000 minimum.

Few investors realise you can buy bonds this way and that by using this direct method it is commission-free. Before investors take the plunge into a government bond, it is worth keeping in mind that for the money all Australian banks have the government's deposit guarantee - effectively making these deposits as safe as an Australian government-backed bond. However, before you assume these bonds must be the best, be aware that government bonds such as these are always low yielding.

Over a longer term, the key problem with bonds is the way that inflation can eat away at them. Over the past 42 years the US sharemarket (S&P 500) had increased ten-fold, just mirroring the increase in inflation. Of course, as well as the price increase from the market investors would have received a flow of generally increasing dividends over the 42 years.

However, consider an investor who invested in either cash or bonds, which do not systematically increase in price. Exposure to a ten-fold bout of inflation would have reduced their purchasing power by 90% over the 42 years.

Over longer periods shares have shown themselves to be a much better hedge against inflation than fixed interest (cash or bonds) type investments. Consider the headwinds that a US-based share investment has encountered over the 42 years while still providing a good hedge against inflation;

  • The significant recession and energy crisis of the early 1970s.
  • The double recession in the early 1980s.
  • The savings and loans crisis in the 1980s and 1990s that saw about 750 banks fail.
  • The 1987 stockmarket crash.
  • The Long Term Capital Management crisis.
  • September 11, 2001.
  • The current global financial crisis.


The inflation-linked bond

At the moment, inflation-linked bonds do not represent a large part of the world debt market, making up about $2 trillion of the debt market.

Most inflation-linked bonds issued around the world have one of two structures. They either calculate their interest payments through a multiple of inflation and a coupon rate, or they index the principal of the bond by inflation.

In the US, two popular forms of inflation-linked bonds are the "I" bonds and the "TIPS" - Treasury Inflation Protected Securities.

The I bonds have a set interest payment above the rate of inflation. At the moment that is a payment of 0.1% above inflation.

However, it is worth remembering the interest rates in the US are at all-time lows. In fact, the US Treasury has announced that for the next period no interest will be paid - because of a negative inflation rate. TIPS are more attractive, with an after inflation return of about 2%.

If the Australian government did issue an inflation-linked bond you could assume that all interest payments from that bond would be taxable, which could push the after tax income from such a bond below the inflation rate.

Conclusion

The bottom line is that we don't know what the budget will bring, other than the reality that the Australian government will have a significant amount of borrowing. If an inflation-linked bond is proposed, it will be interesting to see the form in which it is offered.

The reality is that in an environment where the cash rate is 3%, and with the interest payments on a bond taxable, it might not be quite as exciting opportunity as the concept of an inflation-linked bond suggests.

Scott Francis' articles in the Eureka Report 

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