A primer on inflation-linked bonds

Transcription

1 A primer on inflation-linked bonds Vanguard research February 213 Executive summary. What role can Australian inflation-linked bonds play within a diversified portfolio? This paper discusses how inflation-linked bonds work, the structure of the Australian inflation-linked bond market, and the key investment characteristics of inflation-linked bonds. Inflation-linked bonds assist investors to diversify their portfolios by providing protection against inflation. Due to their indexation to the consumer price index, these securities can help investors maintain their returns at or above the level of consumer price inflation. This is beneficial when inflation is high but returns on other asset classes are low. Hence, inflation-linked bonds are a suitable asset class for providing stable real returns to investors in an inflationary environment. The Australian inflation-linked bond market is still small, but is expected to grow through time, and we expect that these securities will play an increasingly important role in Australian investors portfolios. Authors Paul W. Chin Vijay A. Murik PhD Connect with Vanguard The indexing specialist > vanguard.com.au >

2 How do inflation-linked bonds differ from other bonds? Inflation-linked bonds (ILBs) are designed to safeguard the value of coupon and principal payments against the erosionary impact of inflation through time. An investor holding an ILB can be assured that, regardless of the inflationary outcome, the purchasing power of their cash flow receipts will be maintained through time to the extent that their consumption expenditures reflect the consumer price index. The opportunity cost of investing in ILBs is that when other asset classes outperform, returns on ILBs are more likely to simply keep pace with inflation. In Australia, an ILB is structured in the same way as a standard semi-annual coupon paying bond, except that the principal of the ILB is indexed to lagged changes in the consumer price index (CPI), and coupon interest is paid quarterly as a fixed proportion of the indexed principal. Like standard (nominal) Australian government bonds, ILBs are subject to interest rate risk, which increases with duration. We discuss the interest rate risk characteristics of ILBs relative to nominal bonds in the next section. The difference, or spread, between yields on nominal Australian government bonds and yields on ILBs issued by the Australian government (real yields) is known as the breakeven inflation rate (BEI) (Figure 1). BEIs capture one of the key relativities between investing in a nominal bond and an ILB of the same maturity issued by the same issuer. Where the breakeven inflation rate is higher than the actual inflation rate over the life of the bond, the ILB will underperform the nominal bond and vice versa. Given that BEI represent an indicator of the market s inflation expectations, it is a useful tool in ascertaining the relative value of ILBs with reference to nominal bonds. Indexation constitutes the primary means by which ILB holders receive protection against inflation, by specifying how the quarterly coupon payments and the final principal repayment on the ILB are pegged to the consumer price index. 1 Consider the cash flow profile of the 22 Treasury Indexed Bond (Figure 2). The blue and green bars are as if the bond is paid as a standard coupon paying bond. 1 Deflation can decrease principal on inflation-linked bonds. However, there are measures in place to protect inflation-linked bond holders from effects of deflation. See the Appendix for more details on the indexation. Figure 1 Yield curves for nominal Treasury bonds and Treasury indexed bonds, 28 September 212 4% 3 Yield (per cent) 2 1 Break even inflation Tenor (years) Treasury Indexed Bond yield curve Nominal Treasury Bond yield curve Break even inflation Source: Vanguard calculations based on data from UBS AG, as at September

3 Figure 2 Treasury Indexed Bond 4% August 22 1% % Coupon Principal Aug 96 Aug 98 Aug Aug 2 Aug 4 Aug 6 Aug 8 Aug 1 Aug 12 Aug 14 Aug 16 Aug 18 Aug 2 Real Coupon (LHS) Inflation Coupon (LHS) Real Principal (RHS) Inflation Principal (RHS) Source: Vanguard calculations, based on actual cash flows are shown up to the most recent coupon payment in August 212 (the dashed line). Thereafter, projected cash flows are shown, with an assumption of 2% inflation under indexation. The effects of indexation are shown in the red and purple. Figure 2 demonstrates that indexation has a significant effect on cash flows through time, reflecting a smoothed version of the price level. Consequently, it is clear to see how an investor receiving these cash flows could have reduced their exposure to inflation risk over this period. 2 Another type of inflation-linked bond, the inflation indexed annuity, is defined in terms of a stream of cash flows linked to the consumer price index. As inflation indexed annuities are a small and illiquid segment of the Australian inflation-linked bond market, we do not discuss them in any further detail in this paper. Structure of the inflation-linked bond market In Australia, the ILB market is a small but growing component of the overall bond market, with a total market capitalisation of AUD 42.5 billion (Figure 3). ILBs are issued by the Australian Government, selected States and various corporations. The ILBs that we have been discussing up to this point in the paper are denoted capital indexed bonds in Figure 3, because the indexation is applied to the principal or capital of the bond. 2 Figure 3 The inflation linked bond market and its subsectors, 28 September 212 Australian Bond Market $842.bn Nominal Treasury Bonds $24.5bn Australian Inflation Linked Bond Market $42.5bn Capital Indexed Bonds $38.1bn Inflation Indexed Annuities $4.4bn Commonwealth $26.6bn States $8.4bn Corporate $3.1bn States $1.6bn Infrastructure $2.8bn Sources: Vanguard calculations based on data sourced from UBS, Westpac, as at September

4 Figure 4 Market value of Treasury indexed bonds, 28 September Market value (AUD billion) 2 August August February September September 23 Source: UBS AG, as at September 212. Figure 3 shows that Australian Government ILBs are the major segment of the market, with a total market value of AUD 26.6 billion (and a total face value of AUD 16.5 billion). As they are issued by the Australian Government, Treasury Indexed Bonds (TIBs) are the highest credit quality securities in the ILB market. For the same reason and given their status with the highest volume on issue, TIBs are also the most liquid securities in the market. TIB issuance is spread across five lines, and tends to be quite long in tenor (Figure 4). This affects the sensitivity of the value of TIBs to changes in interest rates, as reflected in the modified duration of each line. For example, at the end of September 212, the modified duration of the 22, 222 and 225 TIBs was 6.9, 8.9 and 11.1, respectively. The first ILB in Australia was issued by the Australian Government in The Government introduced ILBs to diversify funding sources. Investors with long term liabilities, especially those Figure 5 Treasury indexed bond market through time 3, 25, Million ($AUD) 2, 15, 1, 5, Face Value Market Value Source: Barclays, as at September

5 Figure 6 Nominal and Treasury Indexed Bond yields (along with Breakeven Inflation) 16% Yield Indicative Breakeven Inflation 1Y Nominal Longest Treasury Indexed Bond Source: Vanguard calculations based on data sourced from RBA, as at September 212. Note that the real yields are for the longest inflation linked bond on issue. with a need to manage inflation exposures such as pension and superannuation funds, provided a natural clientele for ILBs. Since the first issuance of TIBs, the market grew gradually over time, however new issuance of TIBs was suspended (with existing issues being allowed to run off without refinancing) from 23 to 29 by the Australian Government to reflect the lack of need for debt funding arising from Australia s strong fiscal position during this period. Existing issues were allowed to mature over this period, and market liquidity was relatively low, leading to a general lack of interest in ILBs from many institutional investors. The Australian Government reopened the TIB market in 29 to assist in the financing of the budget deficit that arose in that year, following the Global Financial Crisis. TIB issuance increased significantly in 21 and 211 (Figure 5). The Australian Government made a commitment in the 211/12 Budget to maintain the TIB market at 1% to 15% of the total market for Commonwealth Government Securities (including Treasury bonds and Treasury notes). The larger amounts on issue should contribute significantly towards increasing liquidity in the Australian ILB market in the future. Considerations for Inflation-Linked Bond Investments The performance characteristics of ILBs tend to be directly comparable with those of nominal bonds. This flows from the high predictability and narrow range of outcomes one would expect from high-quality fixed income instruments. As illustrated in Figure 6, real and nominal bond yields tend to move in tandem over time, but not perfectly so. The chart also shows that ILBs tend to have lower yields than nominal bonds, to price for the fact that an ILB s capital value will rise with inflation, resulting in an inflation-indexed coupon stream. From Figure 7 the historical return distributions of nominal and ILB indices tend to be broadly similar, with ILBs exhibiting a wider return distribution reflecting the cost of insurance against expected and unexpected inflation. In addition, the ILB index has also shown fatter tails compared to the nominal index, along with a positive skewness relative to Treasuries. As with most fixed income instruments, yields are important drivers of performance for ILBs prices tend to respond to changes in real interest rates. ILBs respond to interest rate changes just as nominal bonds do prices will decrease (increase) as real yields increase (decrease). 5

6 Figure 7 Monthly return distributions: Inflation linked bonds versus nominal bonds Frequency % UBS Australian Treasury Index Monthly Return Barclays Australian Treasury Inflation Linked Index Sources: Vanguard calculations based on data sourced from UBS AG and Barclays, as at September 212. In contrast, nominal bond prices react to expected future inflation so yields tend to be high when inflation expectations are also high. Whilst ILBs are generally classified as a specific type of fixed income security, their expected performance should not be conflated with the typical return dynamics of Australian Treasury bonds. ILBs can be subject to material price volatility that is due to the typically longer duration: the relatively higher duration can lead to higher sensitivity to short and medium term changes in real yields ultimately leading to a higher level of volatility compared to nominal bond portfolios (Figure 7). ILBs can play a beneficial role in further diversifying a portfolio comprised of equities and nominal bonds. While other asset classes may help assist investors to offset or outperform inflation (to the extent that the CPI index to which the securities are linked matches changes in the price level of the investors liability profile), these relationships can vary dramatically over time especially where the inflation is unexpected, resulting in periods where the apparent hedge is ineffectual. For example, (Figure 8), nominal fixed income and property are solid inflation hedging asset classes where the market expects rises in the price level, however, where inflation rises in an unexpected fashion, only ILBs and physical commodities continue to provide protection against the erosion of real portfolio returns arising from inflation. Drilling into the source of the difference between inflation and the ILB returns, the inflation-linked principal is by construction highly correlated with CPI inflation, so the differences are due to changing real yields in the market, and the aggregate effects of inflation coupons in total returns. Wallick and Marshall (29) note that for investors looking to protect their portfolios from the risk of unexpected high inflation, Treasury Inflation-Protected Securities (TIPS) have a role to play in U.S. portfolios. The return profile of Australian ILBs versus Australian treasuries on a historic basis has been broadly comparable, underlining the close relation of this sub asset class to traditional fixed income securities. Nonetheless, during the global financial crisis, correlations between returns on the two asset classes have dropped significantly in line with global discounting on sovereign debt (Figure 9). 6

7 Figure 8 Rolling 12 month returns, different asset classes versus annual inflation 5% S&P ASX 3 Total Return UBS Composite UBS Bank Bill Barclays Aust. Gov. Inflation Linked Inflation Sources: Vanguard calculations based on data sourced from S&P, UBS, Barclays and RBA, as at September 212. Australian Equities Australian Fixed Income Cash Australian Inflation-Linked Annualized total return 7.% 6.8% 5.4% 8.4% Modified duration month return volatility 13.4% 3.2%.3% 4.9% Minimum 12-month return -4.5% -6.2% 3.4% -1.% Maximum 12-month return 56.7% 2.1% 8.1% 21.5% Correlation to stocks 1.% -21.3% -18.5% -12.8% Correlation to aggregate bonds -21.3% 1.% 25.4% 66.2% Correlation to cash -18.5% 25.4% 1.% 1.5% Correlation to inflation 11.7% 5.2% 7.4% 15.1% Notes to table: Australian equities is S&P/ASX 3, Australian Fixed Income is UBS Composite, Cash is UBS Bank Bill, Australian Inflation-Linked is Barclays Australian Treasury Inflation-linked. Period is July 1997 to June 212. Correlation to inflation has been calculated on the basis of rolling annual returns on the four asset classes to annual inflation (where the frequency of the analysis is quarterly). As far as ILBs versus Australian equities are concerned, the results are even more marked; correlations have remained consistently low, underlining the diversification benefits for portfolios. During bull markets (in the lead up to the global financial crisis, as depicted in Figure 1) where yields are rising, ILBs tend to lag equities from a performance perspective as the inflationary protection is less valuable in these periods. Conversely, in difficult investment periods, ILBs are likely to outperform as a result of holding a fixed income exposure in a falling yield environment. Vanguard research has found differentials in the inflation tracking ability of U.S. ILBs across various maturities. According to Davis et. al. (212), shorter maturity ILBs issued by the U.S. Treasury appear to track inflation more closely as their returns are dominated by the coupon component, whereas longer maturity ILBs tend to be more sensitive to movements in real yields, such that their price changes dwarf the effect of coupons. However, in Australia there are only five outstanding Australian government ILB lines, so it will remain to be seen with further issuance and the development of market liquidity whether these maturity effects translate to our market. 7

8 Figure 9 Annual returns: TIBs vs Treasuries 25%.9 Annual Return Rolling 5Y Monthly Correlation Calendar year UBS Australian Treasuries Index Barclays Australian Treasury Inflation-Linked Index Rolling 5Y Correlation (RHS) Sources: Vanguard calculations based on data sourced from UBS AG and Barclays, as at September 212. When considering the practicalities of investing in ILBs, it is worth noting the prohibitively high minimum investment into most individual ILBs of A$5,. This means that individual investors have been challenged in readily accessing these exposures. The relative illiquidity of issues has acted as an additional deterrent. Nonetheless, the emergence of inflation-linked managed fund (and now more recently exchange traded fund) offerings has provided greater choice beyond nominal bonds, cash and bond derivatives for investors seeking greater certainty in real return outcomes. Specifically, managed funds generally facilitate efficient access for investors to the inflation tracking and diversification properties that a carefully defined basket of ILBs can bring to a portfolio. Figure 1 Annual returns TIBs vs Equities 4% Annual Return Rolling 5Y Monthly Correlation Calendar year -.3 S&P/ASX 3 Accumulation Index Barclays Australian Treasury Inflation-Linked Index Rolling 5Y Correlation Sources: Vanguard calculations based on data sourced from UBS AG and Barclays, as at September

9 Conclusion Where extended time frames are involved, investors should be concerned about the detrimental effects of inflation on the real values of portfolios: rising price levels can compromise an investor s real spending power in relation to cash flows accruing to his or her portfolio. ILBs, as one of the most effective instruments available to investors in managing the effects of inflation, can play a key role, subject to a number of issues we have considered in this paper. For investors globally, inflation risks will undoubtedly increase as a result of heightened uncertainty in financial markets combined with exceptionally expansionary central bank policies. In contemporary times, prices for ILBs have reflected this environment, reaching price highs and corresponding low yields with short-term interest rates globally approaching zero compounded by slowing real economic growth. There is consequent perceived risk that investors wrongly timing investments in such securities could suffer capital losses where prices fall (Davis et al, 212). As a result, there is a temptation to dismiss these core benefits given nearer-term dynamics, however, the reasons for employing a moderate allocation to this tool in portfolios regardless of environment remain enduring and compelling. Finally, as populations in developed countries such as Australia experience a surge in aged individuals, an array of related retirement portfolio issues also gains prominence. For portfolios where achieving strong real returns is an overarching objective, ILBs can help protect against unexpected changes in inflation. In confronting such challenges, investors should gain comfort from tools such as ILBs and their overall attributes, as well as appreciating their ability to protect against unexpected changes in inflation alongside other assets with favourable inflation tracking characteristics, such as long bonds and swaps. ILBs are not risk free and should be viewed as long term investments with a real role to play in portfolios centring around diversification against risky assets, and its inflation matching properties. Especially in uncertain market and economic times where it is notoriously difficult to accurately anticipate inflation dynamics, employing a carefully crafted exposure such as ILBs can assist in achieving real return targets within portfolios. For investors, the recently foreshadowed developments in ILBs by the Australian Government around increasing issues and promoting greater depth should ultimately improve their attractiveness as a tool for Australian investors pursuing stable long term real returns. 9

10 Appendix This Appendix describes the underlying mechanics of the indexation process. See the Treasury Indexed Bonds Information Memorandum, dated 21 July 211, issued by the Australian Office of Financial Management for full details. The indexation of principal takes place each quarter, and is calculated with reference to the Australian Bureau of Statistics release of consumer price index data, For the March, June, September and December data, the CPI data is released on the 4th Wednesday of the following month. The initial principal of an inflation-linked bond, as at the quarter before it is first issued, is set at par (a price per hundred of 1.). The value of the principal at each successive quarterly coupon date is set equal to the previous principal times the average change in the consumer price index over two designated quarters. These quarters are the two quarters ending in the quarter which is two quarters prior to that in which the next interest payment falls. The averaging in the indexation smoothes out spikes in the CPI series. The lag in the indexation makes the first future cash flow known, and mitigates against any irregularity in the next release of CPI data. The measures in place to shield ILB holders from effects of deflation can be described as follows. First, principal repayment will be always at a minimum of 1.. Second, if principal falls below 1., coupon payments are still to be paid on a principal of 1.. However, if any coupon payments are made in this manner, succeeding interest and/or principal payments will be reduced by the difference between the interest amount which was paid; and the payment which would otherwise have been made, with reference to principal which is below 1.. Given the general trend of positive inflation through time, the passing of time since the first issuance of the ILBs (known as seasoning) protects against the decrease of principal due to deflation. For example, if the next coupon is in August 212, then the consumer price index values from September 211 to March 212 are used. The coupon paid to investors is then a fixed proportion of the principal at each coupon date. 1

11 References Ang, Andrew, Min Wei and Geert Bekaert, 28. The Term Structure of Real Rates and Expected Inflation, 63(2) Journal of Finance, Bennyhoff, Donald G., 29. Preserving a Portfolio s Real Value: Is There an Optimal Strategy? Valley Forge, PA: Vanguard Investment Counseling & Research, The Vanguard Group. Bhardwaj, Geetesh, Dean J. Hamilton, and John Ameriks, 211. Hedging Inflation: The Role of Expectations. Valley Forge, PA: The Vanguard Group. Brynjolfsson, John B., 25. Inflation-linked Bonds. (Chapter 15 in Fabozzi, Frank J. (ed) 25. Handbook of Fixed Income Securities. New York, NY: McGraw Hill.) Campbell, John Y., Robert J. Shiller, and Luis M. Viceira, 29. Understanding Inflation-Indexed Bond Markets, NBER Working Paper Cambridge, Mass.: National Bureau of Economic Research. Christensen, Jens H. E., Jose A. Lopez, and Glenn D. Rudebusch, 21. Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields. 42 Journal of Money, Credit and Banking, Davis, Joseph H., Roger Aliaga-Diaz, Charles J. Thomas, and Nathan Zahm, 212 (forthcoming). The Long and Short of TIPS. Valley Forge, PA: Vanguard Investment Counseling & Research, The Vanguard Group. Donaldson, Scott J., Christopher B. Philips, and David J. Walker, 212. Treasury Inflation Protected Securities: Inflation protection still has risks, Valley Forge, PA: Vanguard Investment Strategy Group, The Vanguard Group. Finlay, Richard and Sebastian Wende, 211. Estimating Inflation Expectations with a Limited Number of Inflation-indexed Bonds, RBA Research Discussion Paper Sydney, Australia: Reserve Bank of Australia. Gerard, Hugo, 212. Co-movement in Inflation, RBA Research Discussion Paper Sydney, Australia: Reserve Bank of Australia. Gurkaynak, Refet S., Brian Sack, and Jonathan H. Wright, 28. The TIPS Yield Curve and Inflation Compensation. Finance and Economics Discussion Series, Federal Reserve Board Working Paper No Washington DC: Board of Governors of the Federal Reserve System. Norman, David and Anthony Richards, 21. Modelling Inflation in Australia, RBA Research Discussion Paper Sydney, Australia: Reserve Bank of Australia. Wallick, Daniel W. and Jill Marshall, 29. TIPS and the nature of Inflation Protection, Valley Forge, PA: Valley Forge, PA: Vanguard Investment Strategy Group, The Vanguard Group. D Amico, Stefania, Don H. Kim, and Min Wei, 29. Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices, FRB Finance and Economics Discussion Paper Washington DC: Board of Governors of the Federal Reserve System. Deacon, Mark, Andrew Derry, and Dariush Mirfendereski, 24. Inflation-Indexed Securities: Bonds, Swaps, and Other Derivatives. Wiley Finance. 11

12 Connect with Vanguard The indexing specialist > vanguard.com.au > This paper includes general information and is intended to assist you. Vanguard Investments Australia Ltd (ABN / AFS Licence ) is the product issuer. We have not taken your circumstances into account when preparing the information so it may not be applicable to your circumstances. You should consider your circumstances and our Product Disclosure Statements ( PDSs ) before making any investment decision. You can access our PDSs at vanguard.com.au or by calling Past performance is not an indication of future performance. This publication was prepared in good faith and we accept no liability for any errors or omissions. 213 Vanguard Investments Australia Ltd (ABN / AFS Licence ). All rights reserved. 12 Vanguard, Vanguard Investments, and the ship logo are the trademarks of The Vanguard Group, Inc. ICRPILB 1213