Ordinary Australian bonds have never traded at a negative yield as many European bonds did in 2015 but in the inflation linked bond market there have now been two instances of a negative yields at an ILB tender. ILBs are bonds that have the capital amount adjusted by the quarterly inflation rate thereby protecting investors from the effects of inflation. Well, that’s the theory.
Normally the rate received is a positive number above the inflation level. However, this week an ILB sold at a negative yield at tender. The investors in this instance are locking in a return that is below the level of inflation. The AOFM ILB tender was sold to 8 bidders at a ‘real’ yield of -1.69bps (i.e. 1.69bps below the level of inflation). This is the second time that an ILB tender has been sold at a negative yield with a tender in April being sold at -7.63bps for the same bond series.
Why would investors lock in a return below inflation for three years?
Inflation in Australia to the end of June 2015 was 1.50% and ordinary 3y bonds are currently priced at around 1.80%. If inflation stayed the same over 3 years the real return would be 0.30%. In other words the purchasing power of the funds invested would have increased by 30bps. If inflation rose above 1.80% over the 3y period then the bond investor’s purchasing power would be eroded.
So an investment in an ordinary bond runs the risk that if inflation rises sharply, the investor’s real return would be negative. That is, below the level of inflation. So if inflation was to rise sharply, investing in an ILB for 3 years would see the nominal returns rise commensurately albeit, in this case, less 1.69bps.
That is one of the reasons why an investor might buy ILBs at a negative yield. Effectively it is a 1.69bp option against inflation rising sharply.
There are other reasons of course that include many life offices and insurance companies having mandates to invest in such bonds or liabilities that match the investment profile of an ILB.