Hitch a ride on inflation

By Brent Sheather

It is a little ironic that, while complex hedge fund vehicles have apparently become hugely popular in New Zealand - among financial advisers anyway - low risk investors confronted with deflation and inflation risks can find a simple solution to each of these problems in the government bond market.

For anyone seriously concerned that prices and economic growth are going to decline, as in Japan, long dated conventional government bonds guarantee to provide a steady income while everything else goes out the back door.

If your nightmare is inflation, you will sleep easier with some inflation-indexed government bonds under the pillow.

Conventional bonds are reasonably popular among private investors, but the attractions of their inflation-indexed cousins are less well known.

This is unfortunate because they potentially have a lot going for them, especially if it turns out that Mr Greenspan and Co have overdone things pre-empting a global recession.

Inflation in most places around the world is low now, but there are some ominous signs.

The gold price, a leading indicator of inflation, is up by 9 per cent in US dollar terms since September 30 and long term government bonds have sold off heavily (minus 2.95 per cent) in the past six months as economic prospects have improved.

In the same period, inflation-adjusted bonds have returned 2.6 per cent, implying diversification benefits not to mention a good return.

Why the difference? Interest rates are determined by three main variables - an inflation component, a risk component and the need for real returns.

Inflation-indexed bonds differ from conventional bonds in that they protect capital and income from unexpected inflation, the major determinant of interest rate volatility.

Conventional bonds usually protect investors only from expected inflation.

In the past six months, worries about future inflation have spooked the conventional bond market a little.

Even a small amount of inflation can erode capital over the long term - 3 per cent a year for 10 years will reduce the real value of savings by more than one-third.

Inflation-adjusted bonds were first issued by Treasury in 1995, with a 2016 maturity. Their key features are:

* A coupon of 4.5 per cent a year is payable on the face value of the bond, paid quarterly in arrears. But because the bonds are trading at a small discount to face value, the pre-tax yield is now about 4.66 per cent.

* The face value or capital value of the bond is indexed to inflation, as measured by the consumer price index, so that at maturity the holder benefits from the purchase of the bonds at a discount and the inflation indexation of the capital.

* As the capital value of the bond rises at the rate of inflation and because the coupon of 4.5 per cent is payable on the inflation component, income is thus indexed to inflation.

Coupon payments are made quarterly.

Bonds with a minimum of $10,000 face value can be bought through stockbrokers, financial advisers and some banks.

The bad news is that both the coupon and the capital indexation are subject to taxation, although the indexation is not received until maturity or sale.

This means that each year the capital value or face value of the bond is increased by CPI movement but, although you don't receive this increase in cash until the bond matures or is sold, you do have to pay the tax on it.

This reduces the after tax cash yield of inflation-indexed bonds dramatically, making them unsuitable for investors who need the highest income possible from their investments.

But anyone saving for retirement or a trustee charged with maintaining the real value of a trust's assets can probably make a good case for including a few in the portfolio.

But if inflation really gets away, shooting up to 12 per cent a year, say, the impact of taxation reduces the bonds' return to just below the inflation rate. But, in this scenario, just about anything will be better than holding long term conventional bonds.

Inflation-indexed bonds have another important advantage. Even though they are long-dated instruments they can be expected to do their job - hedge inflation risk - reasonably precisely over the short term as well as the long.

Other instruments, such as shares, are not so precise. Text books and fund managers say shares and property will maintain the real (after inflation) value of their savings, they can often do so only over the long term. Short term, anything can happen.

Last year, for example, the typical global share portfolio fell by 12 per cent when inflation was 2 to 3 per cent.

Many investors do not have the luxury of investing for the long term, so inflation-indexed bonds can be especially attractive to them.

History suggests that conventional bonds, too, are likely to produce a real return in the long run but, if inflation expectations change dramatically, as they have done in the past six months, there can be a substantial depreciation of principal in the short term.

Take 10-year Transpower bonds for example. Six months ago, the yield on 2010 Transpower was 7.10 per cent. Today it is 7.42 per cent and $20,000 worth of Transpower bonds bought last October are now worth $19,617.61.

Similarly the fundamentals of conventional bonds (a high coupon with the repayment of principal in nominal terms) means part or all of the interest needs to be reinvested to be assured of maintaining the real value of investment.

With inflation-indexed bonds, the real value of the principal is guaranteed in all but the most extreme scenarios.

Another way of understanding the relative attractiveness of the bonds is to calculate what rate of inflation is needed to produce the same rate of return as conventional bonds of a similar maturity and then to see how this figure compares with long term historic inflation rates.

At the moment, inflation-indexed bonds yield around 4.66 per cent plus inflation and 2013 government bonds yield 6.91 per cent. So inflation would have to average 2.25 per cent a year over the next 14 years for indexed bonds to produce the same yield.

Is that realistic? Over the past 10 years New Zealand's inflation rate has averaged 1.8 per cent. Economists are picking it to average around 2 per cent or so over the next five years.

Since 1995, the margin between long term Government bonds and inflation-indexed bonds has averaged 1.89 per cent. On the basis of inflation staying around the 2 per cent a year level, indexed bonds look fairly priced relative to long term bonds, but holders are also getting free insurance against inflation racing away.

At a time when insurance costs for anything are sky rocketing, the prospect of free insurance against runaway inflation is worth a second look.

* Brent Sheather is a Whakatane sharebroker and investment adviser.