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Inflation and the RBA

Inflation’s Back on the Table and the RBA is on Watch in 2022. What Should Investors Do?

The outlook for inflation has been getting considerable airtime lately − especially with US monthly inflation hitting 7%. Investors can simply look at the Australian 10-year government bond yield to get an idea of how the market has priced in increased inflation expectations in Australia over the first few weeks of 2022. For example, since the start of 2022, the Australian 10-year government bond yield has risen by c.0.35% (i.e., from 1.6% to 1.95%).

Australia’s Q4 2021 inflation data is due out on 25 January 2022. The Q3 2021 data pointed towards higher underlying inflation and it’s likely that Q4 2021 will also show further acceleration in underlying inflation – there are still supply chain pressures following COVID-19, alongside higher aggregate demand with domestic factors such as government policies and vaccination rates playing an important role.

Chart 1. Australian Government 10-Year Bond Yield

Source: Bloomberg

The question is no longer whether we are seeing an acceleration in underlying inflation, but rather if this is the start of a new structural cycle of higher underlying inflation. Global factors as well as domestic policies will drive underlying inflation.
However, inflation expectations and wages growth will be the key inputs to monitor. Digging deeper, wages growth is what guides most economic models on the trimmed mean inflation and breakeven 10-year inflation rate.

While the labour market has tightened, wages growth is only back to pre-COVID-19 levels and still typical of low inflation. However, increased wage growth is likely to come through over 2022 and into 2023, lifting underlying inflation. The RBA may then be forced to act to ensure inflation and interest rates are normalised.

Investors would be well served to have inflation protection through inflation-linked bonds, either through capital indexed bonds (CIBs) and/or indexed annuity bonds (IABs). An investor holding these types of securities would benefit as the bond principal or capital price is indexed via inflation.

Thus, investor returns are hedged during a period of higher inflation. This is contrary to nominal corporate bonds, where the capital price is directly impacted via higher inflation and higher long-term interest rates.

Table 1. Inflation Securities on Offer

Issuer ISIN Payment Rank Security Type Rating (S&P, Fitch, Moody’s) Maturity Date Real Yield Total Yield
Sydney Airport Finance AU3AB0000085 1st lien Capital Indexed Bond BBB+, WD, Baa1 20-Nov-30 1.05% 4.05%
MPC Funding AU300MPCF018 Sr Unsecured Inflation Linked Annuity AA-, N/A, N/A 31-Dec-33 0.60% 3.60%
Jem NSW Schools II AU300JEMF025 Sr Unsecured Inflation Linked Annuity N/A, N/A, A1 28-Nov-35 0.70% 3.70%
New South Wales Treasury Corp AU3TI0000734 Sr Unsecured Capital Indexed Bond AA+, AAA, Aaa 20-Nov-35 0.10% 3.10%
Civic Nexus Finance AU000CNFL011 Sr Unsecured Inflation Linked Annuity BBB-, BBB, N/A 15-Sep-32 0.50% 3.50%

* Total yield is calculated as real yield + an inflation assumption of 3%
Source: IAM Capital Markets

The risk of higher long-term interest rates would generally be best solved via a shift in exposure from long-term bonds (i.e., 10-year securities) to medium-term bonds (i.e., 3-5-year securities). Being cognisant of credit risk and security selection, higher-yield investments would also suit investors here as they are generally shorter-duration.

Investors can also consider IAM’s managed fund offering − Fortlake Asset Management (FAM). Excess returns versus CPI have been particularly strong since inception for the Fortlake Real Income Fund (FRIF), with inflation strategies a key part of their toolkit. FAM’s FRIF aims to protect investors against higher inflation and uses various derivative instruments.

Table 2. Fortlake Real Income Fund Performance (Net)

31-Dec-21 1M 3M SI
FRIF -0.14% 0.14% 7.64%
CPI 0.25% 0.75% 3.00%
Cash 0.00% 0.01% 0.04%
Excess return vs. CPI -0.39% -0.61% 4.64%
Excess return vs. Cash -0.14% 0.13% 7.60%

 

Source: Fortlake Asset Management, January 2022

Please speak to one of the IAM Sales Representatives if you think these bonds would be of interest to you.

About Matthew Macreadie

Matthew’s current responsibilities include providing credit commentary/views on the bond market and specific issuers, with the aim of aiding investors to make better risk-return decisions.

Prior to joining Income Asset Management, Matthew spent eight years working as a Credit Portfolio Manager at Aberdeen Standard, where he was responsible for the credit portfolio construction and security selection across a wide range of financial and non-financial sectors.

Matthew began his career at KPMG working in Auditing and Assurance within the consumer and industrials group. Matthew holds a Masters of Applied Finance from Macquarie University and a Bachelor of Commerce from UNSW.

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