Investors in Australian interest rate securities are likely to come across inflation-linked bonds but may not know what they are or how they differ to non-inflation-linked bonds. As part of its regular programme of issuance, the Australian Office of Financial Management (AOFM) routinely issues inflation linked government bonds. The following article aims to highlight the core things investors should know about inflation-linked bonds.
Inflation-linked bonds are securities that have been designed to give investors a level of protection from the effects of inflation, since inflation can substantially reduce the value of an investment. These instruments are generally issued by sovereign governments like Australia, the US, the UK through their state treasuries as a means of reducing their borrowing costs and broadening their investor bases. In Australia, both state governments and corporates have also been known to issue inflation linked bonds, indeed Tascorp issued such a bond in the third week of July 2014.
Such bonds are indexed to inflation and this means that both the underlying principal and interest payments are free to move in line with the inflation rate. In an inflationary environment it can be very important for investors to focus on the real rate of return that they are seeing from their investments, which is a simple calculation that reduces the rate of return by the rate of inflation.
An example of this might be an investor who puts $100,000 in a one year term deposit that pays a return of 3.00 per cent while inflation is running at 2.50 per cent. The real rate of return on the deposit would be 0.50 per cent.
To overcome the value-reducing nature of inflation, inflation-linked bonds can protect investors by contractually linking the bond’s principal and interest payments to an index of the inflation rate, such as CPI: an increase in CPI translates into higher principal values.