Dr Stephen Nash argues that inflation-linked bonds offer more than protection from inflation.
Global government stimulus aimed at increasing growth and inflation in the economy is leading to fear about the possibility of a spike in inflation.
In recent times the Reserve Bank of Australia has kept inflation within its target 2-3 per cent band, but some of you will remember the runaway ‘70s where annual inflation rose to over 17 per cent.
What happens to investors’ portfolios if this occurs again? How do they mitigate against this risk?
The only direct hedge against inflation is inflation-linked bonds. These bonds are tied to the Consumer Price Index (CPI) and their capital value grows with inflation, so that over time the capital value increases.
They are issued by the Commonwealth Government, some of the Australian State Governments and corporations. While it is true equities and property may, to some extent, hedge against inflation, there is no certainty.
Equally, we’d expect floating rate notes, whose coupon payment is tied to the bank bill swap rate (BBSW), to offset inflation through changes to the BBSW; but there’s no guarantee it would mirror a steep rise in inflation, or situations where the BBSW is set significantly under inflation.
Investors at or near retirement should have an allocation to this very special security to give them peace of mind in terms of maintaining purchasing power when they’re no longer working.
The US experience, as outlined below, highlights the effectiveness of a high known real yield (over and above inflation) in a low-growth scenario.
US experience
“When the going gets tough, the tough get going”, as the saying goes.
In the US, things are tough (see Graph 1), and this is reflected in the almost unbelievably low yields on US Treasuries, both nominal and inflation-linked bond.
While the fixed-rate nominal bond rate is low, the inflation-linked bond rate is negative.
When secondary market yields are negative the bond typically still pays a positive coupon, as defined at the time of issue; however, investors receive a yield that is lower than the CPI.
Hence, if the CPI is 2 per cent, and the secondary market yield is negative 50 basis points, then the investor effectively receives 2 per cent less 50 basis points, or 1.5 per cent.
Graph 1 shows the following:
- Investing in short-dated investments has led to low returns and uncertain future returns
- Long-dated nominal investments appear to offer the highest yield, yet this is only around 2 per cent
However, investors need to consider inflation, and Graph 2 shows the performance of floating investments (Fed Funds) and the fixed-rate nominal bond, relative to inflation.
In other words, the US gives us some insight as to what happens in a low-growth, moderate-inflation environment.
Not that Australia is destined to replicate the US experience.
Yet to ignore the experience in the largest, most developed bond market is at your own peril.
Now, looking at what the inflation-linked bond return is, when inflation is accounted for, you can see that the picture is much more supportive of the ILB, as Graph 3 shows.
Graph 3 shows that government inflation-linked bonds still deliver adequate returns when inflation remains moderate in a low-growth environment.
Recent experience suggests that inflation-linked bonds have outperformed nominal bonds, although the critical point remains what interest rate spread, above Government, investors receive.
Here, we can estimate what a US investor might receive if they obtained the same spread above Government that they receive in Australia – roughly 4.5 per cent above the government, or more – using the blue line in Graph 4.
Even in the case of the US, where rates are very low, the sample corporate inflation-linked bond still shows value and the achievement of reasonable returns.
However, to answer this in more detail, we now turn to the Australian experience.
Australian inflation-linked bonds – value is still apparent
While government yields have also fallen dramatically, just like the US, as Graph 5 shows, there are still opportunities in the semi-government inflation-linked bond market (remember all yields in Graph 5 are quoted over and above inflation).
The Queensland Treasury Corporation 2030 inflation-linked bond is offering a yield of inflation plus 2.25 per cent, equivalent to 4.75 per cent based on inflation of 2.5 per cent.
The rush for government debt has provided some outstanding corporate inflation-linked bond opportunities for investors.
Graph 6 shows the Envestra corporate inflation-linked bond return, and the Sydney Airport 2030 corporate ILB return, over and above the Commonwealth Government ILB return.
Importantly, the spread over Government protects the investor from shocks that may occur in the future.
Earning a good spread, when the investor is in a senior position in the capital structure in solid investment credit, is one of the key takeaways from the US.
If 4-5 per cent remains an attractive real return, as it has for many years, then corporate inflation-linked bonds represent an excellent opportunity.
Even if inflation falls to zero, the investor earns the spread above inflation, which is in the 4 per cent to 5 per cent range.
Conclusion
While the Australian experience will remain distinct from the US, we should heed the lessons that emanate from the deepest and most liquid market in the world.
If growth is low, and inflation remains moderate, then nominal bonds and floating rate notes will fail to deliver acceptable outcomes.
However, if an adequate interest spread is earned, as is the case in Australia, then investment outcomes are improved dramatically.
Global uncertainty and volatility mean investors need to consider risk in much more detail compared to the ‘old days’, when being fully invested in equities was the standard and there were few alternatives.
Today, the investment landscape is more challenging, and the need to be more cognisant of risk is widely accepted when compared to prior periods.
While the market has competed away returns in US Treasury yields, and Australian Commonwealth Government inflation-linked bonds, value is left in the semi-government ILBs, and especially the corporate ILBs.
Specifically, the Envestra 2025 ILB and the Sydney Airport 2030 ILB, remain my favourite ILBs at this time.
Note: All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.
Dr Stephen Nash is the director for strategy and market development at FIIG.
