Inflation-linked securities – CPI bonds – are likely to attract renewed interest because of the demographic shift happening in the super industry as it approaches the baby-boomers’ decumulation phase of their investment spans. Super funds should take note too.
Tamar Hamlyn, a principal of fixed interest specialist Ardea Investment Management, has an interesting way of viewing his world. “Most funds are effectively short inflation,” he says.
Ardea, the Challenger-backed boutique formed in 2008 by former fixed interest specialists at Credit Suisse Asset Management, including Hamlyn (and ex-pat New Zealanders Ben Alexander and Andrew Bartlett), has a lot of CPI bonds in its portfolios – up to about 50 per cent – as part of “defensive” inflation protection.
He says that many funds see their equity portfolios as sufficient protection against inflation, which he calls “aggressive” inflation protection. “If equity returns are high enough, that’s okay, but what about when the markets are not that good?”
CPI bonds also fit neatly with another trend, which is the increasing popularity of outcome-oriented investment strategies. “We approach it from our investment objectives and then work backwards from that,” Hamlyn says. “Funds have to primarily change the way they are thinking, and peer-consciousness makes that difficult. But chasing the highest yield is not necessarily going to achieve your long-term objectives.”
Managing CPI bonds requires more “number crunching” than traditional fixed-coupon bonds because of the uncertainty of future price rises. For instance, Ardea has viewed the falling price of oil and its consequences as a short-term distortion and therefore a buying opportunity for CPI bonds. Similarly, the manager has some US inflation-linked bonds in its portfolios too because of widely held views about US inflation accompanying its up-tick in growth. It is conscious, though, of the fact that all its clients are Australian and it’s Australian inflation that matters most to them.
And, back home, there’s now an open debate about whether Australia’s GST should be increased from 10 per cent to 15 or even 20 per cent.
“If it went from 10-15, say, that will have a pass-through rate of 3-4 per cent, maybe more,” Hamlyn says. “That’s basically taking 3-4 per cent off investment returns and there’s unlikely to be the same increase in equities.”
Ardea’s view is that the market has not priced much of the inflation threat from a higher level of GST into CPI bonds as yet, probably because of the political uncertainty surrounding the issue.
Currency changes can also have a big impact on inflation. If the Aussie dollar collapsed, as has happened in the past, Australian inflation could rise more rapidly than is expected in the US.
“When your time horizon is five or 10 years,” Hamlyn says, “it’s the under-appreciated asset classes like inflation-linked bonds, that can come into their own… Things are very unusual at the moment. When interest rates are as low as this, does it make sense to have a big allocation to fixed-rate bonds? Even if they’re of short duration? Being in the inflation-linked market gives you another yield curve to play with.”
Ardea’s view is that Australian inflation will remain low for the next one-two years but may rise rapidly after that. From a demographic point of view, demand for services such as education and health will rise and their share of the household budget will also rise.
Ardea has about $5.4 billion under management, including two inflation-linked comingled funds. It is one of Challenger’s Fidante Partners’ 12 affiliated firms.
Bartlett opened an Auckland office for Ardea in 2011.
* Greg Bright is publisher of Investor Strategy News (Australia)