Regaining the balance in super fund portfolios

In a move that will provide a major benefit to Australian superannuation funds, the Federal Government left the door open in the Budget to issuing index-linked bonds after a six-year break.

I believe this would be a desirable step as the closure of the market in index-linked bonds has contributed to a number of unfortunate effects, especially a growing mismatch in the Australian superannuation industry between assets and liabilities.

It would also be well received by investors, with global trends in asset management supporting the closer matching of assets and liabilities as shown by the strong support for recent issues of index-linked bonds overseas.

Closure of index-linked bond market

As the Federal Government ran down its debts early this decade, it recognised the supply problems in the Commonwealth Government Securities (CGS) market and decided to stop issuing index-linked bonds, to concentrate exclusively on nominal bonds.

The closure of the Commonwealth index-linked bond market led many investors to stop considering index-linked bonds as an investment. This is unfortunate, as index-linked bonds play a crucial role in helping to match the assets of a portfolio with its liabilities.

Usually, liabilities have a relationship with the underlying measure of inflation, the CPI. While some have argued that the relevance of the CPI is limited to defined-benefit plans, I believe that defined-contribution plan members also expect a return that at least keeps pace with inflation.

In addition, since the defined-contribution plan has fixed contributions, it is problematic to revise these contributions in the light of investment performance, unlike a defined-benefit scheme, which can adjust contributions if investment performance is disappointing.

While a defined-benefit plan is typically careful to ensure that inflation and interest rate durations are hedged, the requirement to hedge may be even greater in the case of the defined-contribution market.

As Australian superannuation funds generally need to hedge inflation, one expects they would be doing so. However, this is not the case.

Australian superannuation funds typically assign a large weighting to equities of around 50 per cent and very little allocation to index-linked bond securities.

Australian Prudential Regulation Authority (APRA) data indicates that the average allocation to Australian and global fixed income is just 18 per cent and, in practice, this allocation rarely includes any significant allocation to inflation-linked securities.

It is possible that such large allocations to equities are made by Australian funds because there is a relationship between equity returns and the CPI.

However, considerable doubt exists regarding the existence of such a relationship, except in the long run.

A different explanation of the large allocation to equities might be that the extra return derived by equities justifies their poor performance as a hedge for inflation.

However, while betting on equities has been spot on for some time, recent equity performance is fast eroding confidence in the asset class.

Global trend

Semi-government issuers have done much to satisfy demand in the index-linked bond market.

However, the Federal Government still needs to address the issue as soon as possible, as it will increase the diversity of the funding base for the Government and also stimulate investor interest.

In addition, issuance in Australia would follow the now entrenched global trend towards index-linked bond issuance, where the bonds are becoming a global asset class in their own right that supplements nominal bonds. The major issuers are the governments of the US, Europe, Japan and the UK. This issuance is satisfying a demand from investors to more closely match liabilities with assets.

Importantly, the recent surge in global government index-linked bond issuance is helping to facilitate world best practice in asset management, where assets are closely matched to liabilities.

Government leaves the door open

Recently, the Commonwealth indicated it would consider re-issuing index-linked bonds, based on investor demand. The Australian Office of Financial Management subsequently stated that the issuance of index-linked bonds would have the following benefits:

n it would widen the range of available debt instruments;

n it would assist with the pricing and hedging of longer-dated indexed bonds, especially infrastructure debt; and

n index-linked bonds “have advantages for investors with inflation-linked liabilities”.

In other words, the Federal Government has recognised the important role of index-linked bonds in portfolios.

Relative value to equities, diversification

In the aftermath of the global financial crisis and the Federal Government’s response in terms of fiscal stimulus, its need to issue debt has increased.

Equally, the need to balance its issuance requirements with investor needs, and to diversify its funding base, will mean that the Federal Government will soon issue index-linked bonds, effectively reopening this important market.

All these pressures and considerations are converging to force this very important change in the Australian investment landscape at a time when index-linked bonds are not expensive.

For example, the NSWTC 2025 index-linked bond is currently trading over 3.50 per cent real, so with a current inflation rate of 2.5 per cent, the yield is around 6 per cent for a government debt instrument, which is not a bad return.

If investors are fearful of inflation, then the yield on the security will rise with inflation, so a 5 per cent inflation rate would see the security yield 8.5 per cent, and so on.

If investors think that the bond is risky, given the length of the security, they should think back to what they have already purchased in the form of an equity — that is, a perpetual dividend stream to a corporation. In other words, a government-guaranteed security with a maturity date of 2025 is not that risky, when compared to equities, both in terms of issuer risk and term.

Moreover, the security helps to diversify a portfolio of investments that might only contain equities and cash, so if the economy does falter, the value of this security can be expected to rise, thereby offsetting expected losses in equities.

Implications for asset allocation

When the issuance of index-linked bonds occurs it will stimulate demand from many of the large superannuation plans. One might expect an allocation to index-linked bonds across the entire investment market of between 2 per cent and 5 per cent.

In an investment market of around $1 trillion, that is a substantial shift.

In addition, this may contribute to a closer matching of assets to liabilities in the superannuation industry, which is global best practice. Not only will large institutional funds adopt this approach, but it may well become more widely accepted for smaller funds and the retail investor.

Following on from these developments, some form of regulation that enforces asset allocation across age bands may well eventuate, given that a viable Australian dollar index-linked bond market will soon exist.

One might reasonably anticipate that regulation may soon force older investors to hold smaller equity holdings and more index-linked bonds, as well as other fixed income.

Dr Stephen Nash is head of strategy and market development at FIIG Securities.