Is now a good time to invest in inflation-indexed bonds?
The New Zealand Debt Management Office (NZDMO) first issued inflation-indexed bonds (IIBs) in 1995. However, the low volumes (the maximum outstanding being just NZ$2 billion), and lack of any follow up issuance, meant the inflation-linked bond market did not flourish at that time. Turnover in the bond waned and investor interest in the issue diminished to the point where it was largely a ‘hold to maturity’ investment for investors.
After a long absence from the inflation linked market, the NZDMO re-introduced inflation indexed bonds in October 2012 in an effort to lengthen the duration of its borrowing and diversify its investor base. The new issuance programme was aimed at broadening the capital markets in New Zealand and offers investors a product to hedge inflation risks in their portfolios (the biggest risk to long-term bond investors). The NZDMO is committed to maintaining inflation-indexed bonds as part of its issuance programme, which means that the market for inflation products should broaden and deepen over time.
Why invest in IIBs?
The real yields attached to New Zealand IIBs are among the highest in global markets (refer to chart 1). This reflects both 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.
CHART 1: 10Y GLOBAL AND NEW ZEALAND REAL YIELDS (%)
Source: AMP Capital, Bloomberg
For investors wanting a high real return (compared to global comparators) New Zealand IIBs are attractive.
CPI Inflation has been low since the beginning of 2012. Causes of this low inflation have been the significant falls in oil and other commodity prices over the period as well as low rates of wage appreciation. However, there is the prospect of inflation picking up in the coming years.
Despite the risk of higher inflation, IIBs do not seem to be pricing this risk. We view them as cheap relative to nominal bonds.
A simple way to look at the value of an IIB is to look at the break-even inflation rate (BEI). BEI is simply the difference between the yield on a nominal bond and the real yield on an IIB with the same maturity. This provides the level at which inflation is expected to average over the term of the bond. Chart 2 shows the 10Y BEI for the New Zealand and global inflation linked bond market.
CHART 2: 10Y BREAK-EVEN INFLATION RATES (%)
Source: AMP Capital, Bloomberg
You will observe the very low level of BEI in New Zealand, sitting around 1% (surprisingly only lower in Germany and Japan). This level of BEI means the market expects New Zealand inflation to average 1% per annum over the next 10 years. We think this is too low given our inflation outlook over 10 years.
Buying New Zealand IIBs at this level provides a cheap way to protect a portfolio from any pickup in inflation above the 1% per annum currently priced by the market.
Is it a good time to invest?
We think it is a good time to consider IIBs in a fixed income portfolio, and we have invested in them in our portfolios. The key reasons for this view are:
From a real yield perspective, New Zealand IIBs offer a superior real yield to other developed markets.
From a BEI perspective, the current BEI for 10Y New Zealand IIBs at 1% is cheap given our outlook for inflation in New Zealand over the next 10 years.
This blog post has been prepared to provide general information and does not constitute 'financial advice' for the purposes of the Financial Advisors Act 2008 (Act).
An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice.
While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate,
complete or timely and do not make any warranties or representations in respect of results gained from its use.
The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP.
These views are subject to change depending on market conditions and other factors.
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