One of the chief concerns of many investors is the effect inflation will have on their retirement savings. With their value linked directly to the Consumer Price Index, Inflation Linked Bonds offer investors the opportunity to protect themselves from inflation whilst earning some of the best returns in the bond market.

What are inflation linked bonds?

Inflation Linked Bonds (ILBs) are bonds which have returns directly linked to inflation. The most common form is the ‘capital indexed bond’ where variations in inflation during the life of the bond are applied to the capital price of the bond.

A simple example would be:

• A bond, with an original face value of $100, has three years to maturity and inflation is 3% per annum for the three-year period. The capital price would thus rise from $100 to $103 in Year 1
• Then in Year 2, the adjusted capital price would be $103 + $3.09 = $106.09 and in year three $106.09 + $3.18 = $109.27 (rounded to two decimal points)
• The issuer would therefore repay the bondholder $109.27 at maturity. While the coupon (interest) margin over CPI does not change throughout the life of the bond, it is paid each quarter on the adjusted capital price. So, your effective cash income increases with the underlying increase in adjusted capital price.

The capital price is adjusted quarterly in line with the Consumer Price Index so ILBs offer SMSF investors an effective way to protect their capital against the ravages of inflation.

ILBs are offered by a variety of issuers including governments and banks, however their generally long dated nature makes them perfect for infrastructure companies whose regulated revenues are often also linked to inflation.

Sydney Airport ILB

Since the start of the GFC, long dated bonds have fallen out of favour with institutional investors. This has provided investors happy to take a longer-term view with their investments the opportunity to take advantage of strong returns over a longer period. Currently, long dated corporate inflation linked bonds are presenting some of the most outstanding value in the market, and Sydney Airport ILBs are currently my preferred choice.

Sydney Airport currently has two ILBs available, one maturing in 2020, the second maturing in 2030. The bonds are offering ‘real’ returns of 4.00% and 4.45% respectively. This means they are offering 4.00% and 4.45% above the rate of inflation:

• If inflation is 2%, the 2020 bond would return 6%,
• If inflation were 3% the 2020 bond would return 7% and so on.

Based on the midpoint of the RBA inflation target (the RBA seeks to maintain inflation between the band of 2% and 3%) the Sydney Airport 2020 ILB would return 6.5% for investors. The 2030 would return 6.95%. Should inflation break out beyond the target band, investors will continue to enjoy a return above the prevailing inflation rate – offering investors a true protection from the effects on inflation on their capital.

The Sydney Airport bonds are ranked at the top of the capital structure being senior secured, backed by this critical investment grade infrastructure asset.

Sydney Airport

Sydney Airport delivered another strong performance in its most recent results with revenue, EBITDA and passenger numbers all increasing. Kingsford-Smith Airport remains the premier air transport hub in Australia and enjoys the most diversified airline client base of any of Australia’s airports. Sydney remains the gateway for international travel to Australia and this, in addition to the largest catchment of any of our capital city airports, underpins the assets’ performance through the economic cycle.

Infrastructure New South Wales recent report “First Things First – The State Infrastructure Strategy 2012-2032” further highlighted the importance of Sydney Airport and it proposes a number of infrastructure projects, which will be positives for the airport and its customers.

One concern I often hear from potential investors in Sydney Airport is the often mooted “second Sydney Airport”. I remain unconcerned with this ‘threat’ for a number of reasons:

• The need for a second airport would only be driven by the full utilisation of the existing facilities,
• The current operators of Sydney Airport retain an option on the development of any second airport
• A second airport will be built in Western Sydney, one of the key strengths of Kingsford-Smith is its proximity to the CBD
• The timing of any second airport would be beyond the 2020 maturities and have minimal effect on the 2030 maturities
• Whilst all levels of government have opinions on the need for a second airport, there remains no motivation to actually fund it.

For investors concerned with the effects of inflation on their investment nest egg, inflation linked bonds offer a true protection, and the Sydney Airport ILBs currently offer some of the best value in the Australian bond market.

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.