A Guide to Exchange-Traded Australian Government Bonds

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Inflation and its Impact on Government Bonds

Inflation is one of the key risks to understand when dealing with government bonds. Investment returns are only positive if purchasing power parity is maintained over the life of the security. This means that it is possible to underperform if inflation is higher than expected returns over the life of the security.

The purpose of investing in government securities is for risk-averse investors to receive income while maintaining purchasing power parity.

What is Inflation?

Inflation is defined by the Australian Bureau of Statistics as an upward movement in the general level of prices, which can impose costs on individuals and the economy. Over time, inflation reduces the purchasing power of money and can lead to market inefficiencies. A low and stable rate of inflation is desirable for the health of the economy. Although inflation is defined as a rise in the general level of prices, not all prices change at the same rate or even in the same direction. For this reason, inflation can also affect the distribution of real income and wealth among individuals and households. This is the key reason why defensive investors in instruments such as government bonds should understand the components of inflation and what will drive future inflationary expectations.

It is the role of the Reserve Bank to set monetary policy based on achieving an average inflation rate of 2 to 3 per cent over the economic cycle. This acts as an anchor for business expectations and gives investors a minimum compound return target over the life of their investment.

Figure 6: Inflation Over the Long Run

Sources: ABS, RBA

How Is Inflation Measured?

There are several regularly reported measures of inflation but the primary measure which is relevant to government bond investors is the Consumer Price Index (CPI).

The CPI, as measured by the Australian Bureau of Statistics, reflects retail prices of goods and services, including housing costs, transportation, and healthcare.

When analysing inflation, investors should focus on "core inflation" rather than the "headline" or reported inflation rate. Core inflation removes volatile components (such as petrol), which can cause unwanted distortion to the headline figure and don't reflect the true medium to long-term trend.

Reported inflation gives us current data, but how do we measure any future inflationary expectations? The most widely-used market-based measures of medium- to long-term inflation expectations are those derived from government bonds. Their use is based on the idea that treasury bond yields have three main components:

• the real yield, which bond investors demand as compensation for postponing consumption (the term risk premium);
• compensation for expected inflation over the term of the bond (inflation risk premium); and
• any potential variation in either of the above two components.
• In academic fields, this deconstruction is known as the Fisher equation.

What are Exchange-Traded Treasury-Indexed Bonds (eTIBs)?

Treasury-Indexed Bonds are government bonds that protect investors from the negative impact of inflation by contractually linking the capital value of the bond to the ABS Consumer Price Index.

Historically, the issuance of inflation-linked securities in Australia has been dominated by the Australian Government. These securities have been in existence since 1983 but have gone through periods of limited issuance. The primary investors in the inflation-linked market have been superannuation funds, life insurance companies and professional fund managers.

These bonds, also known as "linkers," have performed very well over the past 20 years, primarily due to inflation being somewhat volatile and their tendency to be long duration. For this reason, some of the trading prices on eTIBs will look closer to A$200 than A$100.

Table 2. Exchange-Traded Capital-Indexed Bonds

Just like treasury bonds, whose prices move in response to nominal interest-rate changes, the prices of Treasury-Indexed Bonds will change as real yields fluctuate. In the circumstance where an economy goes through a sustained period of deflation, it is possible that the inflation-adjusted principal could decline below its par value. Luckily for investors, the Australian Government offers inflation floors at maturity, which means investors will always receive par (at minimum) at maturity.

Treasury-Indexed Bonds are a defensive alternative for investors seeking to preserve purchasing power. They are less volatile than stocks, commodities or currencies, and given their predictable real return, inflation-linked bonds are arguably a more reliable way to protect against inflation than equities.

History suggests that spikes in inflation can occur without warning, particularly after long periods of low inflation. Similar to an insurance premium, the best time to purchase protection against inflation can be before it starts rising. Investors looking to employ inflation-linked strategies in their portfolios should understand how these securities react to changing market conditions. The best way to understand what the market is expecting for inflation is to understand the break-even inflation rate.

Understanding Breakeven Inflation

In its simplest form, breakeven inflation is the difference in yield between treasury-indexed bonds and nominal bonds for a given maturity (for example, 10-year Treasury Bond yield less 10-year Treasury-Indexed Bond Yield).

This is considered a rough measure of future inflationary expectations. Breakeven inflation encompasses both the expected inflation rate and the inflation risk premium, two components of nominal yields that on their own are not always easily quantifiable. Put another way, breakeven inflation is the future inflation rate required for a real bond to achieve the same return as a comparable nominal bond, if held to maturity.

If actual inflation is more than breakeven inflation, a real bond is likely to outperform the nominal bond. If actual inflation is less than breakeven inflation, the nominal bond is likely to outperform. Breakeven inflation is only a rough measure because a number of factors can influence it, including liquidity and supply and demand.