IABs offer protection against inflationary pressures, making them a crucial allocation during times of high inflation, but also offering many other benefits too. Here we discuss how they work and why they’re considered a core portfolio holding.
Background
There are two types of inflation linked bonds in the fixed income market, Capital Indexed Bonds (CIB) and Indexed Annuity Bonds (IAB). While both types of bonds provide inflation protection, they also have many differences. Here we solely focus on IABs.
In this article we dispel any misunderstandings around IABs, which can be perceived as complex for their unique characteristics.
How they work
Coupon and cashflow
The coupon on an IAB differs from that of a fixed rate or floating rate bond, in that it is quoted as 0%, but this is simply a function of how its cashflow works.
An IAB cashflow is in the form of an annuity stream. An annuity is an equal repayment over the life of a loan, made up of increasing principal payments and decreasing interest payments. When the loan period ends, there is no lump sum payable, but rather
one final principal payment and interest payment- reducing the loan to zero.
In many ways, annuities look similar to a typical home mortgage payment stream, whereby the loan is discussed in terms of a monthly repayment and the length of the loan period.
This type of annuity is also known as a ‘nominal’ annuity, which does not keep pace with inflation, whereas IABs have annuity payments that are indexed to inflation. While IABs pay an equal repayment amount (referred to as a ‘base payment’),
this increases with inflation so that the base payment remains constant in ‘real’ terms, or after inflation.
To give context, the base payment is the minimum total coupon payment each quarter an investor would expect to receive from an IAB if inflation remained at 0% over its tenor. Figure 1 shows this scenario, with the total payment received (base payment)
remaining constant and looks very similar to that of cashflow for a fixed coupon bond. To further illustrate the cashflow of an IAB, the total payment (black line) has been split between interest payments (grey line) and principal payments (blue line)
- showing the interest payment gradually decline, while the principal payments gradually increase.
To demonstrate how the cashflow on an IAB increases with inflation, we have applied an inflation assumption of 2.50% (orange lines) to the base payment (blue lines), per Figure 2.
Since we know the base payment (this is given at time of issuance) and the maturity date of each IAB, we are able to perform a calculation to find the coupon rate for an IAB purely based on the cashflow (assuming 0% inflation) and the number of payments
up to the maturity date. For illustrative purposes, Figure 3 below shows a selection of IABs with these coupon rates (noting they do not include the inflation component) along with their base payment per $100 face value.
Yield
Another unique feature of an IAB is how its return is quoted and calculated, which consists of a margin above CPI. The margin (referred to as the ‘real yield’), is then added to an estimated forward looking inflation assumption to give the
‘nominal yield’, per the formula below. For example, if inflation were to remain at 0% over the IAB’s tenor, then the real yield would also be the nominal yield.
IAB nominal yield = real yield + CPI assumption
To further illustrate this, below in Figure 4 shows a selection of IAB bonds along with their real and nominal yields assuming a 2.50% inflation assumption.
While inflation at times will spike, resulting in a better return via a higher cashflow, the inflation assumption is an average over the life of the bond. For illustrative purposes FIIG typically use 2.50%, which is the middle of the Reserve Bank of Australia’s
(RBA) target range. Another indication on forward looking inflation is the break even rate, which is the difference between fixed rate and inflation linked bond yields at similar tenors. At time of writing, the 10-year break even inflation rate is
2.35% and the 5-year Break even inflation rate is 2.55%.
Figure 5 below shows the domestic quarterly year-on-year (YoY) inflation since 1993, and although currently it’s significantly higher when looking at this 10-year period, you’ll note the average is 2.56% (indicated by the red dotted line),
which is closer to the RBA’s middle range.
Capital price
An IABs capital price will trend lower over its tenor, although this isn’t cause for concern, but rather by design. Similar to most other bonds, IABs are issued at $100 (referred to as par), however unique to this type of security the capital price
slightly decreases following each quarterly payment to reflect the principal that has been repaid, remembering the coupon payment is made up of an interest payment along with a portion of principal.
An IAB’s bond factor shows the amount of remaining amount of principal outstanding at that interest payment in regard to the original amount issued. At issuance, where no principle has been repaid, the bond factor is 1, and this reduces with each
coupon payment to reflect the amount outstanding, until it reduces down to the last payment at maturity. This is also a good indication of how close a bond is to maturity, noting an IAB amortises in full.
To reflect the change in CPI, an IAB is indexed to inflation, with its indexation level adjusted with each quarterly print. It’s an important element to how the IAB cashflow is calculated each quarter, and as such we discuss the concept in more
detail in the following section.
While for a vanilla fixed or floating rate bond it’s clear if the bond is trading at a discount (below par) or premium (above par) to its face value, it’s less obvious for an IAB. However, the ‘par’ value of an IAB can be calculated
by multiplying the IAB’s bond factor with its indexation value, as per the formula below. The bond factor and indexation value are reset following each quarterly payment.
(Bond factor x indexation value) x 100 = par value
For illustrative purposes, we will calculate the par value for the Royal Women’s Hospital IAB, which is currently trading at a clean price of $79.16. The bond’s current indexation value is 1.604, and its current bond factor is 0.47499.
(0.47499 x 1.604) x 100 = RWH IAB par value
(0.76188396) x 100 = $76.18
From this we can see that the current trading price of $79.16 is at a premium to its indicative par value of $76.18.
Solid portfolio holding
While these securities offer protection against rising inflation, they are also a core holding in a balanced portfolio for their defensive nature and strong credit rating.
These bonds were typically issued to finance key infrastructure projects, including schools, hospitals, convention centres and law courts, where the construction stage has been completed and are all in the less-risky operational phase.
The projects receive fixed payments that are not contingent on the amount of patronage/usage or competition risk, but rather the quality and availability of the facilities being managed. This improves the credit profile, reducing seasonal/cyclical
exposures.
Generally, these types of bonds have an investment grade credit rating and the revenue stream is typically from the respective state or state department, which is also reflected in the strong rating.
While some IAB bonds have a longer tenor, for example with maturity dates in 2033 and 2035, they have less duration risk compared to a fixed rate bond of the same tenor. This is as a result of IAB bonds repaying principal over the life of the bond,
rather than a lump sum repaid at maturity. This also reduces the credit risk, with a smaller amount remaining with the issuer until maturity.
The amortisation on an IAB bond also allows an investor to reinvest in other opportunities when they arise, rather than having funds locked up for a longer period of time.
Conclusion
While IAB bonds are sometimes perceived as being complex for their unique features they work relatively similarly to a fixed or floating rate note, although the cash flow is indexed to inflation, the yield includes an inflation assumption, and the
par value needs to be calculated.
We consider IABs to be a core portfolio holding for their non-cyclical nature, strong credit rating and infrastructure exposure.