Significant differences between inflation-linked bonds (ILBs) and traditional bonds make them complementary investments, iShares Australia director Tom Keenan said.
“The value of an inflation-linked bond moves each quarter with changes in the consumer price index (CPI). In this way, the investor receives at maturity an inflation adjusted or ‘real’ return on their capital,” he said.
Tyndall AM head of fixed income Roger Bridges agreed with the potential merits of including ILBs in certain portfolios, but said “they should be included only if they fit with a portfolio’s existing investments and investment aims”.
“ILBs, however, are more uncertain (than fixed-rate bonds) because the real rate earned is fixed with the inflation floating depending on actual inflation. ILBs are not immune to interest rate changes, particularly if they are due to real cash rate changes.
“Given their longer duration, this can actually make them highly volatile. In addition, it is important to note that inflation-adjustment may not always be positive. If the economy were to undergo a period of deflation with sustained price declines, the inflation-adjusted capital could end up being lower than the initial investment amount,” Bridges said.
Ardea Investment Management principal Tamar Hamlyn said ILBs were useful for self-managed super funds to safeguard high allocations to cash, which were currently 28 per cent of SMSF portfolios.
With the lower than expected inflation figure 0.5 per cent for the second quarter, Hamlyn said investors should not become complacent and “now is a good time for investors to increase their inflation protection while it can be accessed relatively cheaply”.
Keenan said the automatic CPI-adjustment feature of the inflation-linked bond differentiates them from traditional ‘nominal’ bonds or floating rate bonds, which simply return back their original investment.
“Inflation-linked bonds do, however, share some traits with traditional bonds. They both pay regular income or a ‘coupon.’ But even on this dimension, inflation-linked bonds have a different flavour,” he said.
“Inflation-linked bonds generally provide rising income over time. This derives from the fact that the income applicable to them is calculated as a fixed percentage of the bond’s inflation adjusted capital value.
“This differs from traditional fixed-interest bonds which pay fixed income. It also contrasts with floating rate investments, including deposits, which provide income that fluctuates with movements in money market rates.”
Inflation-linked bonds merited portfolio-inclusion for three main reasons, he said. Preserving purchasing power was the explicit purpose of ILDs.
Traditional bonds made regular income payments that were unadjusted for inflation. ILBs bonds could bolster portfolio income and help preserve the real value of capital.
ILBs could cushion portfolios against interest rate changes. Swapping from shares to cash simply exchanged equity-risk for interest-rate-risk.
Bridges agreed with Keenan but only if ILBs fitted a portfolio’s existing investments and investment aims.
“ILBs adjust with inflation and the coupon reflects this, but this introduces an element of uncertainty,” Bridges said.
“If an investor buys and holds a traditional fixed-rate bond to maturity, then they know what to expect since it fixes the return to the investor at the time of purchase depending on prevailing real cash rates and expected inflation.”
