Q: Is now the right time to invest in bonds? I was looking at inflation linked bonds and/or an EFT which invests in these and they are trading at a premium to issue price. There is a lot of talk that bonds are in a bubble and will burst when people start moving funds back into equities. Is this only applicable to the US or is this the case in Australia too?
A: Inflation linked bonds (ILBs) are the only security available that is a direct hedge against inflation, that is because the interest payment (coupon) is linked to the consumer price index (CPI). The most common type of ILB is issued at $100 face value (like most bonds) and each quarter the inflation (as measured by the CPI) is added to the face value and this is the revised value the company must repay to the investor at maturity.
The interest payment is also linked to inflation, and would be quoted as say CPI +3% and this would be paid on the increased capital value of the bond. So, if inflation spikes again, as it did in the 1970s and 1980s to double digits (of say 10%), the value of the bond would increase by that amount and the effective coupon would be around 13%, protecting the purchasing power of your portfolio.
I would recommend every investor has an allocation to these securities for their unique protective qualities.
Typically, when market commentators speak of bond bubbles, they are referring to “bubbles” in the pricing of long dated, fixed rate, government securities. In particular, most of the recent commentary about a bond bubble is referring to pricing of US Treasuries, where there is the unique situation where US Treasury yields have fallen below inflation in the US. This reflects the fear in world markets, where investors are more concerned with return of their money rather than return on their money. The bubble is reflective of the ‘flight to safety’ of significant volumes of funds which has in turn pushed the capital price of US Treasuries up.
We’d expect this bubble to burst when world economies settle down and growth returns, allowing the US Fed to lift rates meaning the fixed rate US Treasury bond prices would fall. That said, investors would still be returned the $100 face value of their bonds at maturity.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
