Although the rate of return is attractive, now is a better time than ever to sell indexed annuity bonds while prices are higher and inflation is lower for longer
Investors in any asset class dream of one thing – arbitrage. Strictly, arbitrage is the purchase and sale of securities in different markets at the same time in order to profit from a price discrepancy. Understandably, this doesn’t happen very often and when it does we don’t hear about it until after the fact – the clever investor who notices it first takes full advantage and the opportunity trades away.
Sometimes however, price inefficiencies exist in slightly different ways which mean they persist for years and even decades. Generally this is because they happen rarely and the markets they occur in are illiquid or small. This isn’t strictly arbitrage but it is most certainly an opportunity to book profit or invest cheaply.
This is the case with Indexed Annuity Bonds (IABs). Clients at FIIG are very active in IABs but they are a niche marketplace.
An IAB is a fairly straightforward security. The investor receives a stream of cashflows made up of principal and interest. These payments are indexed to CPI such that the spending power of each one is at least as great as the payment before. In nominal terms, if CPI growth is zero or negative the next payment is equal to the last just like an ordinary annuity; if CPI growth is positive the next payment is larger than the last.
The Consumer Price Index is a measure of the “movements in retail prices of goods and services commonly purchased by metropolitan households” and growth in the index is commonly referred to as ‘inflation’. Given the Reserve Bank has a target of 2 3%p.a. for CPI, the measure is mean reverting – if it strays too far from this band the RBA will use monetary policy to shift it.
The formula by which IAB prices are calculated assumes that the next inflation number will be the same as the last inflation number. Clearly, where the last CPI number has been dramatically high or low compared to the average, then this creates an anomaly. This also applies where the next CPI number is predicted to be dramatically higher or lower than the current figure.
Figure 1: The next annuity payment is the previous payment, increased by the CPI growth. Up until the CPI release, CPIt is unknown. To give you an example, the current CPI figure released this morning (0.5% quarter on quarter) was higher than the previous figure. Given the last print was negative, we had a high degree of confidence that this would be the case. The table below shows the prices for Royal Women’s Hospital IAB before and after the CPI release and the corresponding rates of return:
RWH-IAB-0%-30Jun33
Mid market pricing | Pre CPI | Post CPI |
| Settlement date | 29/07/2016 | 29/07/2016 |
| Maturity | 30/06/2033 | 30/06/2033 |
| Real yield | 3.62% | 3.62% |
| Price | 92.383
| 92.437
|
∆ price
| | +0.054 |
Source: Bloomberg
As shown above, the bonds were more expensive immediately following the CPI figure even though rates of return were unchanged, simply because of a technicality in a small market. The magnitude of the price difference would have been larger if the CPI figure had been larger. Confidence around direction and magnitude of CPI allows investors to time their entry or exit into these securities and should continue to do so.
This discrepancy applies to all IABs, not just Royal Women’s Hospital. Whether an investor chooses to act on this depends on their view as to growth and the direction of rates, and will be subject to liquidity. We continue to have the view that the inflation linked component of portfolios provides an important hedge that is hard to achieve elsewhere, and will recommend the IABs where the real rate of return is attractive, but if you have been thinking about selling IABs, today is a better day than yesterday.
Bibliography
1. Australian Bureau of Statistics. 6401.0 Consumer Price Index, Australia, Mar 2016. [Online] April 27, 2016. [Cited: July 27, 2016.] http://www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/6401.0Mar%202016?OpenDocument
2. AFMA. Inflation Product Conventions. Australian Financial Markets Association. [Online] March 2016. http://www.afma.com.au/standards/market-conventions/Inflation%20Product%20Conventions.pdf.
3. FIIG Securities Ltd. Australian Guide to Fixed Income.