Bonds: Protecting your clients' retirement income from inflation

Let’s assume you advise a couple, Mr and Mrs White. The Whites are about to retire with a reasonable balance in their super. They are both in good health and likely to enjoy a lengthy retirement. You have seen their budgeted income and expenditure figures and, while their overall needs are modest, longevity of more than 20 years will exhaust their joint superannuation.

Their situation will be made worse if inflation over the period is higher than your forecasts. Accordingly, in constructing their investment portfolio, your strategy must lean heavily towards preserving their capital over the longest possible term, while taking into account their requirement for rising (in response to inflation) regular income.

Concluding that they need a truly defensive portfolio offering low-risk and income-producing assets, could inflation-linked Commonwealth Government and semi-government bonds provide the Whites with a suitable investment option?

Description

The most common type of inflation (or index) linked bond (ILB) is a capital indexed bond (CIB), where changes in the consumer price index (CPI) are reflected in the principal value of the bond. Adjustments reflecting quarterly movements in the CPI are also made to the principal of the CIB on a quarterly basis. The fluctuating principal value of the bond is known as the ‘base payment’.

It follows that if the CPI was 2.5 per cent in one year and the base payment at the start of the year was 100, by the end of the year the base payment would have moved up to 102.5. Coupons payable after the end of the year will be calculated on the adjusted base payment of 102.5, pending further adjustments. In other words, not only does the base payment move with inflation but also the coupon payment, which is calculated on the adjusted principal. Thus, CIBs provide a direct hedge against inflation.

In contrast, nominal bonds (or fixed-interest bonds) retain a base payment of 100, so they do not provide a direct hedge to inflation.

The decision on whether to purchase an ILB or a nominal bond should take into account the following considerations:

1. If your clients purchase a fixed-income stream of, say, 5 per cent derived from a nominal bond and inflation rises substantially, the fixed-income stream may not be sufficient to cover their living expenses. Additionally, capital value may fall if they decide to liquidate the bond.

2. If they purchase an ILB they will probably receive a lower coupon initially, but the investment return will increase, with a rising CPI maintaining the real overall yield. In short, your clients are buying protection or insurance against inflation, as well as a moderate income stream.

Capital indexed bonds — features

The indexing of CIBs occurs quarterly on the capital or principal amount of the bond, which is repaid at maturity. The indexation factor is based on the rate of consumer price inflation, represented by the CPI. Interest is generally payable quarterly on the then current indexed capital amount at a fixed coupon rate (say 4 per cent per annum).

Assuming the inflation indexation increases the principal value, or ‘base payment’, of the security over time, the amount paid at maturity becomes greater. For example, if the base payment in year one was 100, and inflation was 10 per cent in year one, the base payment would move to 110 in year two and the security would pay 4 per cent of the base payment. Hence, the income would be calculated as follows:

• In year one, the base payment is 100 and the coupon is 4 per cent, so the income is calculated by multiplying the base payment by the coupon, or 4 per cent multiplied by 100 (or 1), which generates income of 4 per cent.
• In year two, the base payment increases from 100 to 110, as inflation in year one was 10 per cent. The income is calculated by multiplying the base payment by the coupon, or 4 per cent of 110 (or 1.1), generating income of 4.4 per cent.

During negative periods of inflation the coupon will be paid on a decreasing principal. However, under the Australian system, the final payment can never be less than the original capital value at issue.

While unlikely in this case, highly taxed investors in CIBs should be alerted to the possibility of negative cash flow in times of high inflation, leading to a very large portion of the overall earnings being derived from indexation (ie, the tax payable exceeds the coupon payment).

Inflation scenarios

In Table 1 we consider the following inflation scenarios so as to demonstrate the way ILBs hedge against inflation using a theoretical bond issued at par in April 2008, with a (real) coupon of 4.5 per cent, maturing in April 2017:

• Scenario A: inflation is constant at 2 per cent per year, commencing in April 2008, and going out to 2017;
• Scenario B: inflation is constant at 1 per cent per year, commencing in April 2008 and going out to 2017, with one year of 1 per cent deflation; and
• Scenario C: inflation is constant at 4 per cent, commencing in April 2008 and going out to 2017.

As the table indicates, the indexed-linked security has an overall return stream, which floats up and down with inflation. In the higher-inflation Scenario C, the ILB accrues a principal payment that is much larger than under the other scenarios, and the coupon rises as well. Here, the ILB protects the investor from the possibility of inflation rising substantially. Under the other scenarios the principal increases, but not as quickly, reflecting the subdued inflation environments.

You can also compare the theoretical ILB to a theoretical nominal bond issued at par in April 2008 with a coupon of 7.25 per cent, and maturing in April 2017. Here, you can see that the returns are fixed and not affected by changes in the CPI, indicating how well the ILB performs in a high-inflation environment.

What if the Whites’ circumstances change?

In the event the Whites’ circumstances change or they both pass away before the maturity date of the bonds, the following issues may have some bearing on liquidation of the securities.

ILBs are valued in a variety of ways but all methods reflect the fact that ILBs trade on inflation expectations. One popular method is a comparison of the real yield on ILBs with nominal bonds of a similar maturity. If the difference — often being referred to as the ‘spread’ — is large, this indicates the ILB is expensive in relation to the nominal bond. During 2008, set against the anticipated absence of new issuance, ILBs became expensive as ongoing demand drove real yields down. As you would expect at the time, the spread between the nominal and ILB was larger than normal.

During late 2008 and 2009, market participants realised that the large funding task ahead of the Commonwealth would lead to new issuance of ILBs. Accordingly, market participants have pushed out real yields in anticipation of the issuance. ILBs are not as cheap as they have been recently but the spread between ILBs and nominal bonds is still quite low relative to recent trading history, suggesting that ILBs may still be relatively cheap at present.

Another way to value ILBs is the outright level of real yields, relative to the recent past. ILBs, on that basis, still offer reasonably good value.

Importantly, however, the market for ILBs normally remains liquid and you could reasonably expect the bid/offer margin to be minimal.

What is a reasonable portfolio allocation to ILBs?

ILB securities provide a direct hedge against inflation so that the principal invested in the ILB keeps pace with changes in inflation over the period of investment. Concluding that no other investment provides such a long-term direct hedge against inflation, we believe these securities should form a core part of most investment portfolios, something in the order of at least 5 per cent to 15 per cent of a portfolio of investments.

Allocations to ILBs should generally vary with the age of the investor, as the ability of the investor to take on risk varies inversely with age; younger investors can generally assume more investment risk, relative to forecast liabilities, than older investors. This would suggest that while the average allocation to ILBs might be 8 per cent to 10 per cent, a younger investor might allocate 5 per cent, while an older investor might allocate up to 50 per cent.

Why not use equities as a hedge against inflation?

While the argument for investing in ILBs is strong, the typical allocation of an Australian superannuation fund does not reflect this. In particular, the average Australian superannuation fund has around a 50 per cent market value weighting to equities and no, or very little, allocation to index-linked securities.

The Australian Prudential Regulation Authority (APRA) figures suggest that the average default allocation to Australian and global fixed income is 18 per cent and, in practice, this rarely includes any significant allocation to inflation-linked securities. Table 2 shows comparisons to inflation linked securities. Table 2 shows comparisons with other OECD countries, indicating that portfolio weightings in Australia to fixed income are well below the OECD average.

In general, if an investor or fund uses an asset allocation model identified by APRA as being fairly typical in Australia, and there is a future liability stream linked to Australian CPI, the potential risk and return characteristics of this asset mix suggest:

• the portfolio will offer an inadequate hedge against adverse market conditions;
• the portfolio will deliver an inadequate return for risk; and
• the portfolio’s diversity of assets is inadequate.

Conclusion

Commonwealth Government or State Government ILBs will offer the Whites a low-risk, long-term investment for their retirement. The allocation to ILBs will provide the Whites with a reliable quarterly cash flow with protection against erosion of value from inflation.

While their coupon return may initially be a smaller income than they can earn from a government-guaranteed (until October 2011) term deposit, they will have the comfort of knowing that their future income will be shielded from the potential indirect inflationary effects of the stimulus packages introduced of late by many countries around the world.

Turning to the question of what is an appropriate allocation from the Whites’ portfolio to ILBs, a cautious approach would be to invest an adequate sum to generate income that is sufficient to cover the Whites’ essential expenses.

There is a good argument for clients who are on tighter budgets and less able to withstand a rise in inflation making a larger allocation to ILBs. As Table 2 shows, ILBs perform well in periods of higher inflation.

In the case of the Whites, a decision to limit their investment in ILBs would need to be supplemented by low-risk income securities to generate adequate cash flow to cover their expenses. Such alternative securities would need to offer a reasonable premium over the ILB coupon rate to offer some protection against future erosion by rising inflation.

Taking a broader outlook, ILBs have not been readily available for some time. This lack of availability has distorted the Australian superannuation market compared to other advanced economies. While ILBs have been embraced in other countries for reasons outlined above, a closed ILB market has effectively prevented these securities from being used in Australian asset allocation. All of this is likely to change with the launch of the Commonwealth Government ILB issue on September 29 (the first issue since 2003, and likely the first of many).

As Australian investors and fund managers participate in the global best practice of matching assets with liabilities, a rising demand for ILBs can be anticipated.

Stephen Hart is head of planner services at FIIG Securities.