Inflation linked bonds

Posted On Friday, 22 February 2002 14:01 Published by
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A low-risk investment that protects your capital and income fully against inflation. What may sound like a dream is a reality, compliments of SA's National Treasury's inflation-linked bonds
A low-risk investment that protects your capital and income fully against inflation. What may sound like a dream is a reality, compliments of SA's National Treasury's inflation-linked bonds.

All the asset managers are buying them because they like the protection, especially during a time of rising inflation. But they are also accessible to individual investors.

The principles underlying inflation-linked bonds are simple. The interest rate, or coupon, is set at the open-market auction of the bond and remains fixed throughout the bond's life. To compensate for inflation, regular adjustments are made to the bond's capital value.

If, for example, a bond is issued at a coupon yield of 5,5%, a R1m investment will initially produce an interest income of R55 000/year. If inflation over the next year is, say, 6%, the capital value on which the 5,5% interest rate is payable is adjusted upwards by 6%. In our example this will increase the capital value to R1,06m and the interest payable to R58 000.

In effect, both capital and income are protected against inflation's erosion of real value.

Inflation-fighting investors have two government bonds to choose from, the R189 and R197, and one parastatal bond, the Trans-Caledon WS05. The R197 and WS05 have the attraction of being long-dated, maturing in 2023 and 2018 respectively. But with about R13bn worth of stock in issue, the R189, maturing in 2013, is by far the largest and most practical investment.

You don't have to be a multimillionaire to invest, says Leon Krynauw, a director and head of fixed-income trading at stockbroker Barnard Jacobs Mellet (BJM). 'We trade in odd-lots of as small as R20 000 in the R189.'

The R189 pays interest bi-annually in March and September, based on capital values adjusted monthly in terms of the change in the consumer price index (CPI). This index includes changes in mortgage bond interest rates, a variable not measured by CPIX, the index used by government for inflation targeting.

Because of the timing of CPI statistical releases, the rate used is behind by three months, says Krynauw.

Renewed inflation uncertainty, says Krynauw, has driven the yield on the R189 down from 5,4% in August 2001 to about 4,7% at present. For bonds, falling yields mean rising prices and vice versa - simplistically put, a bond paying R10/year interest and priced at R100 when interest rates are 10% will cost R200 at a 5% yield.

An investor who bought R189s at their initial issue in March 2000 at a 6,25% coupon yield has enjoyed capital appreciation from both the decline in the bond's yield and the CPI adjustment. The R189's current clean price, which excludes accumulated interest due for payment, is now 26% up on March 2000's issue level, with the rising CPI responsible for just under a 9% increase in value.

Investment in the R189 at its current 4,7% yield hinges on inflation rate expectations and must be compared with the 12% yield obtainable now on conventional bonds such as the government R153. The comparison is equally applicable to bond market unit trusts.

Assuming that the current 'real' yield of 4,7% on the R189 remains constant, a 5%/year average CPI over 10 years will increase its capital value by 63%.

Total income received over the period will equal a similar 60% of original purchase cost.

The impact of a 10%/year average CPI over 10 years is far more profound. Still assuming a 4,7% constant 'real' yield, the R189's value will increase by 160% and the total income earned will equal about 80% of the original purchase cost.

The low-risk aspect of the R189 is perhaps best illustrated by the fact that total income of 120% earned over 10 years on a conventional bond yielding 12%/year equals the total capital plus income return on the R189 at a 5%/year average CPI.

That capital appreciation is subject to capital gains tax, at a maximum of 10,5%, while interest earned is subject to higher rates of income tax adds further weight to the investment merits of CPI-linked bonds.

On a risk/reward trade-off only a sharp decline in inflationary expectations would appear to favour conventional bond investment at present. While this eventuality cannot be excluded over the longer term, current indications do not appear favourable for vanilla bonds.

To what levels bond rates could climb is hard to judge. But based on a long-term historical 3,5% average real interest rate (nominal interest rate minus the inflation rate), a 9,6% CPI should be enough to push the R153 a further one percentage point higher to around 13%.

Publisher: Financial Mail
Source: Financial Mail

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