Like death and taxes, inflation is a fact of life.
But this does not necessarily spell doom and gloom for investors, explains Gareth Bern, portfolio manager at Prudential. Investing in an instrument that adjusts to changing inflation, like inflation-linked bonds (ILBs), can mean the difference between sleepless nights over movements in the inflation rate and having peace of mind irrespective of the figures.
Adjusted for the effects of inflation
ILBs, as the name suggests, are bonds whose returns are explicitly linked to the inflation rate. They are also referred to as "real" bonds in that they are quoted and priced to provide a return after adjusting for the effects of inflation.
"This provides the investor who holds them to maturity with a means to preserve and hopefully grow the purchasing power of their investment," explains Bern.
Interest, principal adjusted for inflation
South African ILBs make interest payments on a periodic basis in much the same way as a traditional fixed rate bond. The difference is that ILB interest payments are adjusted for what inflation has been over the period.
Importantly, it is not just the interest payments that are adjusted for inflation but also the principal value of the bond.
"The initial principal grows with inflation so that, when it is eventually repaid on maturity, the investor receives the initial principal investment plus whatever inflation has been over the period of the investment."
For example, if an investor bought a one-year ILB for R1000, and inflation averaged 10 percent over the year, the maturity value of the bond at the end of the year would be R1100. If inflation had only averaged five percent for the year, then the investor would receive R1050 on maturity.
The yields on ILBs therefore appear low at first glance because they don’t reflect the additional return the investor will receive to compensate for the effects of inflation.
ILB cash flows are only received at maturity
The ILB interest payments are adjusted based on the inflation rate; whereas the fixed rate bonds interest payments remain the same.
"Note how the bulk of the cash flows from the ILB are received on maturity of the bond rather than through interest payments," Bern emphasises. This is because the initial investment is adjusted for inflation, but this inflation adjustment is only paid to the investor on maturity of the bond rather than with the annual interest payments.
ILBs don’t carry inflation risk
While the ILB investor assumes no inflation risk the fixed rate bond investor retains all the inflation risk.
"Although it’s not possible to say with certainty which will be the better investment, as one needs to know what inflation will be, the ILB does provide the option to avoid the risk that inflation turns out to be much higher than expected," explains Bern.
In other words, ILB investors can lock in their real rate of return and be protected against unexpectedly high inflation.
ILBs key if you want to earn an inflation-protected return
For investors looking for an instrument that explicitly protects their investment from the effects of inflation, ILBs provide a useful starting point.
If you are an individual investor who wants to access the benefits of inflation-linked bonds, your option include funds such as the Prudential Inflation Plus Fund, which had just over 30 percent of its portfolio invested in these instruments at the end of July 2012.
You may also wish to invest directly in Inflation Linked RSA Retail Savings Bonds at any branch of Pick n Pay or the South African Post Office. Alternatively, go the RSA Retail Savings Bond website (www.rsaretailbonds.gov.za).