Andrew Barrelle has spent the past 10 years thinking about inflation on behalf of some of the world’s largest banks. He has been kind enough to share his thoughts and experience with Bristlemouth. Please note that the opinions provided below are Andrew’s own personal views and not necessarily those of his employer, Royal Bank of Scotland.
Hi Andrew and thanks for sharing your thoughts with us. Firstly, what’s your role at RBS?
I look after the AUD Inflation Trading business at RBS (we were formerly ABN Amro – as of four weeks ago officially part of RBS in Australia). We buy, sell and originate Inflation Linked Bonds and Inflation Linked Swaps and are one of the largest participants in this niche market. There are $20bn of existing Inflation Linked Bonds in the Australian market, with much larger markets in the US, UK, Europe, and even Japan (the land of deflation).
You’ve read Gareth Brown’s views about the potential inflation risks arising from government stimulus. What’s your view?
I spend every working day thinking about inflation, and there has never been a time in the last 15 years where the outlook for actual inflation is more uncertain. On one side you have significant deleveraging and deflationary forces, and on the other an unprecedented government response, including quantitative easing in UK and US (aka the electronic printing press). On balance, I favour higher inflation as governments cannot afford deflation, and hence will over-respond, rather than under-respond.
And what can investors do about it?
For ‘perfect’ protection against the headline inflation, inflation linked or CPI bonds are the lowest risk, best matching asset available for protecting the real value of money over a reasonable term. Given long tenors, credits tend to be super high quality, which further makes them ideal as the base of any portfolio (and much, much better than that great useless metal, gold). The need for inflation protection increases dramatically as one approaches retirement because inflation particularly hurts those with fixed incomes and a fixed capital base. Those lucky enough to be younger hopefully get a lot of inflation protection through wage increases.
The Australian Government has three current bonds (and possibly more soon) issued, with maturities in 2010, 2015 and 2020. There are also bonds issued by NSW, Vic, SA and Queensland. Finally, there are less liquid issues by the banks, property, infrastructure and other Public Private Partnerships, which are often very closely linked to the underlying state government credit. The tenors are typically long (up to 30yrs), which reflects the need for inflation protection over the long term.
What sort of returns do you get from CPI Bonds?
The cost of the lowest risk asset is a low real yield. As a guide, the real yield for the 20/8/2015 Aust. Govt CPI Bond is about 2.50% (+ actual CPI). So if actual inflation averages 5% over the next 6 years, then total return will be approx 7.5%. If actual inflation is 0%, then the return will be 2.50%, etc. Some securities have deflation floors. This 2.50% real yield should be compared to government 2015 nominal bond at circa 4.25% (which gives a break even inflation rate of 1.75% over the next 6 years). Alternatively, it can be compared to cash at 3%. (Note the above examples assume that investors hold the securities to maturity and are wholesale rates).
State Government CPI Bonds tend to have 50-100bps higher real yields. There are a range of other credits available, offering higher yields as the credit worthiness of the issuer decreases. Like all markets at the moment, there are some outstanding opportunities available, if you know where to look…however, there are also some potential disasters waiting to happen.
In Australia, the Index used is the headline Consumer Price Index (CPI) published quarterly by the ABS. The basket measured includes food and oil, but not asset prices directly.
Apart from CPI bonds, what other asset classes to you suggest as useful inflation hedges?
Property is eventually a good hedge. Initially though, one may have to suffer capital mark-to-market losses as, in a very high inflation environment, interest rates will rise. This may lower property prices. So as inflation rises, property prices may initially be falling. Ditto equities in general. Ultimately, however, sustained inflation will increase rent (the earnings) and, over time, will overcome the interest rate effect. But it could take many years (and the benefit probably won’t flow through until the inflation threat has subsided and interest rates are falling).
Equities have been well covered elsewhere – I like LPTs (Listed Property Trusts) and infrastructure companies (eg tollroads) more and more as both leverage and prices reduce. Sydney Airport (as a great shopping centre) has many inflation linked rental streams. The health sector also fits in well (especially if we are hedging longevity too!).
Commodities (such as wheat, corn, coffee, oil and useful metals) should be reasonable ‘real investments’ over time, but with significant volatility and little income. Commodities are generally denominated in USD, so some of their performance is really a short position in USD. Beware.
How would you balance all this up when constructing an inflation-resistant portfolio?
Well, an exact inflation hedge will include only CPI Bonds. This can be achieved through direct investment, or through a managed fund.
However, a higher returning inflation-resistant portfolio may have CPI bonds as the first base investment, but also some direct property, selected equities, low-levered selected LPT/infrastructure, floating rate securities and perhaps commodity exposure. The greater the diversification, the better.
Can a retail investor buy CPI bonds in Australia?
Yes. While the market is predominately institutional ($500k min size, $5m market parcels), many of the above securities are available to retail investors in $1k, $10k or $100k min parcel size. Retail investors can use a retail fixed income broker, such as ABN AMRO Morgans (RBS is a shareholder in this business), RIM securities or FIIG Securities. There is a cost for using these brokers, usually in the form of a lower real yield (higher price) paid. However, they will hold the bonds in safe custody and provide admin over the life of the security. This cost may not be economic for investments smaller than (say) $25k.
For smaller investors, a managed fund may be a more cost effective way to achieve this exposure. I believe UBS Asset Management and CSAM Asset Management offer retail inflation linked bond funds locally. There is also a range of international “real return” funds, with PIMCO the most well known, but many other offered by large global fund managers.
Thank you, Andrew. Those insightful comments are much appreciated.