Inflation Indexed Bonds versus Nominal Bonds

All normal (or nominal) bonds, and other fixed-income securities, are exposed to deterioration in real value if there is prolonged inflation, creating the risk that the purchasing power of interest payments could be eroded by inflation.

However, there is protection from rising inflation through inflation-linked bonds. Commonly known as linkers, they are a unique asset class because they offer a direct hedge against inflation and a low correlation to other risk assets – hence why these securities provide diversification to many portfolios.

What is a bond?

A bond is a ‘debt investment’. When an investor buys a bond he or she is loaning money to the borrower (an organisation or entity), and in return the borrower undertakes to pay a specified rate of interest (or coupon), and to repay the face value of the bond when it matures.

Why invest in bonds?

A diversified bond portfolio provides an income at lower levels of risk than shares, and may offer higher income than money market funds or term deposits. Due to their focus on capital preservation, bonds can be appealing to risk adverse investors such as those nearing or in retirement.

What are nominal bonds?

Nominal bonds are not linked to inflation and are issued with a fixed principal amount, a fixed coupon rate and date. For example, a two-year bond of $1 million at 5% interest (divided by two years). The $1 million will be returned to the investor at the end of two years.

Inflation Indexed Bonds (IIBs)

New Zealand IIBs are capital indexed bonds (CIBs), which means that they pay a fixed coupon on a principal indexed to movements in the Consumer Price Index (CPI) inflation. At maturity, both the original principal and the additional indexed principal are repaid to investors.

Inflation linked bonds protect purchasing power by directly linking returns to inflation for the bonds entire term – in other words they go up or down with inflation – and the principal amount is also adjusted according to changes in the headline inflation rate.

Bond comparison

When inflationary expectations increase, nominal bonds become less attractive as future interest payments are eroded by inflation. When inflationary concerns decrease (including deflation), nominal bonds become more attractive because future interest payments become more valuable on a real (or after inflation basis). 

Why invest in IIBs?

The real yields attached to New Zealand IIBs are among the highest in global linker markets. This reflects higher than average nominal yields (and associated risk and Liquidity premia) in New Zealand, but also the cheapness of New Zealand IIBs relative to other global inflation linked bonds.

Is this a good time to invest in IIBs?

From a real yield perspective, New Zealand IIBs offer a superior real yield to other developed markets. From an inflation and break even inflation perspective (BEI), the current BEI for 10 years New Zealand may be good value given the outlook for inflation in New Zealand over the next ten years.

For more information or to discuss if inflation indexed bonds are right for you, call our team on 0800 102 100 or send an email to spicers@spicers.co.nz to find out more about the current opportunities available to New Zealanders.

Inflation Indexed Bonds versus Nominal Bonds

All normal (or nominal) bonds, and other fixed-income securities, are exposed to deterioration in real value if there is prolonged inflation, creating the risk that the purchasing power of interest payments could be eroded by inflation

All normal (or nominal) bonds, and other fixed-income securities, are exposed to deterioration in real value if there is prolonged inflation, creating the risk that the purchasing power of interest payments could be eroded by inflation.

However, there is protection from rising inflation through inflation-linked bonds. Commonly known as linkers, they are a unique asset class because they offer a direct hedge against inflation and a low correlation to other risk assets – hence why these securities provide diversification to many portfolios.

What is a bond?

A bond is a ‘debt investment’. When an investor buys a bond he or she is loaning money to the borrower (an organisation or entity), and in return the borrower undertakes to pay a specified rate of interest (or coupon), and to repay the face value of the bond when it matures.

Why invest in bonds?

A diversified bond portfolio provides an income at lower levels of risk than shares, and may offer higher income than money market funds or term deposits. Due to their focus on capital preservation, bonds can be appealing to risk adverse investors such as those nearing or in retirement.

What are nominal bonds?

Nominal bonds are not linked to inflation and are issued with a fixed principal amount, a fixed coupon rate and date. For example, a two-year bond of $1 million at 5% interest (divided by two years). The $1 million will be returned to the investor at the end of two years.

Inflation Indexed Bonds (IIBs)

New Zealand IIBs are capital indexed bonds (CIBs), which means that they pay a fixed coupon on a principal indexed to movements in the Consumer Price Index (CPI) inflation. At maturity, both the original principal and the additional indexed principal are repaid to investors.

Inflation linked bonds protect purchasing power by directly linking returns to inflation for the bonds entire term – in other words they go up or down with inflation – and the principal amount is also adjusted according to changes in the headline inflation rate.

Bond comparison

When inflationary expectations increase, nominal bonds become less attractive as future interest payments are eroded by inflation. When inflationary concerns decrease (including deflation), nominal bonds become more attractive because future interest payments become more valuable on a real (or after inflation basis). 

Why invest in IIBs?

The real yields attached to New Zealand IIBs are among the highest in global linker markets. This reflects higher than average nominal yields (and associated risk and Liquidity premia) in New Zealand, but also the cheapness of New Zealand IIBs relative to other global inflation linked bonds.

Is this a good time to invest in IIBs?

From a real yield perspective, New Zealand IIBs offer a superior real yield to other developed markets. From an inflation and break even inflation perspective (BEI), the current BEI for 10 years New Zealand may be good value given the outlook for inflation in New Zealand over the next ten years.

For more information or to discuss if inflation indexed bonds are right for you, call our team on 0800 102 100 or send an email to spicers@spicers.co.nz to find out more about the current opportunities available to New Zealanders.

Inflation Indexed Bonds versus Nominal Bonds
Important information

The content on this website is for information only. The information is of a general nature and does not constitute financial advice or other professional advice. Before taking any action, you should always seek financial advice or other professional advice relevant to your personal circumstances. While care has been taken to supply information on this website that is accurate, no entity or person gives any warranty of reliability or accuracy, or accepts any responsibility arising in any way including from any error or omission. A disclosure statement is available from your adviser on request and free of charge.

 

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