Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Register

10 January 2025

Home / Caveat Emptor

Inflation linked bonds

Question from Douglas

Do long dated inflation linked bonds help the investor in a rising interest rate environment?

 

Answer from Elizabeth Moran, Director of Education and Fixed Income Research, FIIG Securities

The simple answer is yes, insofar as the Reserve Bank of Australia (RBA) uses its control of interest rates as its primary mechanism to control inflation, so interest rates should only rise if inflation is rising.

Principal and interest on inflation linked bonds are linked to inflation (as measured by the Consumer Price Index, or CPI), so the value of these assets will increase as inflation rises.

As an example, the Sydney Airport Finance capital index bond maturing in November 2020 is currently yielding a quarterly coupon of CPI plus 4.65%. If CPI averages 2.50% (which is the middle of the RBA target band) over the remaining life of the bond, this bond will yield 7.15%. However, if inflation rises at some stage over the life of the bond, and averages 3.50% over that period, that directly translates into an additional 1% annual return on the bond, increasing the yield to 8.15%.

2 Comments
Warren Bird
December 09, 2013

The more complex answer is that it depends on your time frame. Inflation linked bonds, like nominal bonds, fall in price for a while when yields rise. Whatsmore, inflation-linked bonds are longer duration* than nominal bonds of the same final maturity date, so the capital price impact is going to be greater.

Of course, as I harp on about a lot, for an investor in a portfolio of bonds who correctly looks at their investment for a time horizon similar to the duration of the portfolio, this needn't put you off. The rising real yield means that maturing linkers can get reinvested into the market at those higher real yields. A fall in bond prices is never permanent - every inflation linked bond will mature at an inflation-adjusted value of 100.

But if you have a shorter term time horizon than that, then inflation linked bonds might not be suitable for capital preservation. Every investor is different and needs to talk to their planner about their needs.

It's possible for nominal yields to rise while the real yield on an indexed bond to remain unchanged. That happens when the market simply pushes up bond yields because of higher inflation expectations. That's a great outcome for holders of inflation linked bonds as they get a lift in the nominal value of their assets and their interest payments due to the higher inflation. But it's rare and usually you get some increase in the real yield as well when nominal yields rise.

In the current climate the big fear that many people have is that real yields will return to 'normal' (whatever that is these days!) In which case, most of any increase in market yields is likely to be almost fully reflected in real yields. This has already happened to some extent over the past year or so as bond yields have risen from their very, very low levels of mid-2012. Inflation linked bonds have pretty much fully reflected this increase, and the longer duration means that their total return has been well below that of nominal bonds.

I don't want any of that to put people off buying inflation-linked bonds, because they are a suitable investment for many long term portfolios. But please do understand that there's more to them than just 'inflation up, bond value and interest up', so that you aren't surprised or disappointed at the short term fluctuations.

There are a few brokers around, like Curve Securities or FIIG, who can source Sydney Airport inflation linked bonds, and other fixed interest assets for clients who have 'wholesale' amounts of money to invest.


* see my Cuffelinks article http://cuffelinks.com.au/term-deposit-investors-did-not-understand-the-risk/ for an explanation of duration risk. It's not as scary as many think!

Esther
December 09, 2013

Hi

How do i buy into Sydney Airport Finance capital index bond? are these Bonds registered in ASX??

thanks heaps!

 

Leave a Comment:

RELATED ARTICLES

Bonds have a role in managing inflation risks

Australia joins the PIIGS

Why allocating more to fixed income now makes sense

Firstlinks is sponsored by:
banner

Most viewed in recent weeks

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

Australia’s shameful super gap

ASFA provides a key guide for how much you will need to live on in retirement. Unfortunately it has many deficiencies, and the averages don't tell the full story of the growing gender superannuation gap.

9 lessons from 2024

Key lessons include expensive stocks can always get more expensive, Bitcoin is our tulip mania, follow the smart money, the young are coming with pitchforks on housing, and the importance of staying invested.

The 20 most popular articles of 2024

Check out the most-read Firstlinks articles from 2024. From '16 ASX stocks to buy and hold forever', to 'The best strategy to build income for life', and 'Where baby boomer wealth will end up', there's something for all.

2025: Another bullish year ahead for equities?

2024 was a banner year for equities, with a run-up in US tech stocks broadening into a global market rally, and the big question now is whether the good times can continue? History suggests optimism is warranted.

Time to announce the X-factor for 2024

What is the X-factor - the largely unexpected influence that wasn’t thought about when the year began but came from left field to have powerful effects on investment returns - for 2024? It's time to select the winner.

Latest Updates

Shares

Howard Marks warns of market froth

The renowned investor has penned his first investor letter for 2025 and it’s a ripper. He runs through what bubbles are, which ones he’s experienced, and whether today’s markets qualify as the third major bubble of this century.

Property

What to expect from the Australian property market in 2025

The housing market was subdued in 2024, and pessimism abounds as we start the new year. 2025 is likely to be a tale of two halves, with interest rate cuts fuelling a resurgence in buyer demand in the second half of the year.

Superannuation

How to fix the Commonwealth Superannuation Scheme

The scheme has not been updated since it was established and is no longer fit for purpose. Members now find themselves disadvantaged in several important ways versus those in other superannuation funds.

Investment strategies

5 key investment themes for the next decade

AI has helped markets to new highs and rightly dominated news headlines. Yet there are other themes, including niche ones such as gene editing, which are also expected to drive investment returns over the next decade.

Shares

New avenues of growth make 2025 exciting for investors

Investors need to be more discerning this year as headline valuations are high and the economic cycle turns. Dig a little deeper, though, and there are big opportunities in overlooked shares with strong tailwinds.

Investment strategies

The pros and cons of debt recycling strategies

Debt recycling is a powerful strategy for those juggling the seemingly competing goals of debt reduction and building an investment portfolio. Yet it's often misunderstood because it isn't just a single strategy.

Investment strategies

Australia is out of step on nuclear power

Globally, nuclear power is gathering momentum as a differentiated power source in the energy transition to zero carbon emissions. Yet in Australia, a nuclear ban remains, making us an outlier among our Western Allies.

Sponsors

Alliances

Site Map

About Firstlinks

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.