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Jul 01

Is there value in inflation linked bonds?

The RBA provides daily reporting on three Treasury Capital Indexed bonds. They each mature in the month of August in 2010, 2015, and 2020 and are currently yielding 2.40%, 3.11%, and 3.02% respectively as at 30th June 2009. If we compare these Capital Indexed yields to the Treasure Fixed Rate yields for similar maturing securities we achieve the market’s estimation of inflation over the term to maturity.

The yield of the Treasury Fixed Rate Coupon Bond maturing August 2010 is 3.45% indicating the expected inflation through to August 2010 is 1.05% (i.e. 3.45% – 2.40%) which is clearly very low.

Applying the same logic using April 2015 and April 2020 Fixed Rate Bond yields of 5.32% and 5.62% respectively we achieve an inflation outlook of 2.21% and 2.60% over each respective term.

The inflation outlook is:

  • 1.05% to August 2010
  • ~2.21% over the next 6 years to 2015, and
  • ~2.60% over the next 11 years to 2020

Whilst I agree that inflation is likely to be relatively low over the coming years, for the fixed rate investor, inflation will always be a significant risk. If you invest in a government bond yielding 5.62%pa over the next 11 years high inflation could easily wipe out any value in this type of investment. As a result, despite, these subdued inflation outlooks, there appears to be significant long term value in inflation linked bonds whilst yields appear to be at historically low levels and also whilst the outlook for inflation appears low.

The risk for the inflation linked bond investor is that inflation turns out to be even lower than the above-mentioned forecast…if you think inflation will be lower than stick to the fixed rate bond, otherwise inflaiton linked bonds are definnitely worth serious consideration.

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