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The More Prices Increase, the More You Earn
Inflation-protected bonds deserve consideration given the probability of rising prices in the second half
The More Prices Increase, the More You Earn
  • By matthew
  • August 2, 2010, 16:22
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Any successful investor is sensitive to fluctuations in interest and exchange rates as well as economic trends at home and abroad. In the second half of this year, the biggest concern of the rich will be inflationary pressure brought about by the probability of rising public utility prices and a recovery in domestic consumption.

Already, we are hearing news of an increase in gas and electricity rates as well as car insurance premium. Therefore, how will these rising prices affect the investment portfolios of high net worth individuals (HNWI)?

The higher inflation is, the more these investors are interested in bonds that are protected from it. Inflation-protected (inflation-indexed) bonds refer to 10-year treasury bonds that pay the principal and interest tied to inflation measured by the Consumer Price Index (CPI).

These are free from inflation risk and guarantee the purchasing power is not lost. While the price of non-protected bonds is affected by the nominal interest rate, the price of protected bonds is affected by the real interest rate, meaning that they are less exposed to interest rate changes. Moreover, even if the nominal interest rate increases due to inflationary pressure, the principal and interest are compensated to keep up with inflation, raising the bond price in return.

Amid the prospect of a rapid increase in inflation based on the current heavy liquidity in the market, inflation-indexed bonds are gaining more and more attention. Against this backdrop, Inflation-Linked Korean Treasury Bonds (KTBi) were issued on June 21 in Korea, the first time since March 2007, without tangible results because of lukewarm demand and a lack of liquidity.

However, lessons were learnt. This time, the issue was successful because conditions that reflect customer needs were offered. The Korean government set the interest rate first before fixing the amount to be issued. Furthermore, it will issue the bonds every month until May 2011 (excluding December) rather than on a lump-sum basis in order to establish a new product smoothly in the market.

Price-indexed bonds are commonly traded in advanced markets such as the United States where they are called Treasury Inflation-Protected Securities (TIPS) or Inflation-Linked Savings Bonds (I-Bond). They account for 8% of the remaining balance of bonds in the US, 15.3% in the United Kingdom and 11.7% in France.

For the average investor, inflation-protected bond funds would be a better choice. Currently, PCA Inflation Protection Securities Investment Trust and Hyundai Global Inflation Linked Securities Investment Trust are available.

Hyundai Global Inflation Linked Securities Investment Trust, the first of its kind in Korea, is put into treasury inflation-indexed bonds not only in Korea but also in the US and Europe.

The principal and interest are adjusted to the inflation measured by the CPIs of issuing countries.

If you buy 10-year bonds with a 5% coupon rate for 100 million won, you get 150 million won at maturity. If you invest the same amount of money in 10-year inflation-linked bonds with a 3% coupon rate, assuming 3% inflation, you are paid about 170 million won worth of adjusted principal and interest at maturity.

The instrument is diversified into different types according to fees and entry methods, thus demanding potential investors to carefully consider their portfolios to obtain maximum return. The product is classified into master and feeder, with investments made largely through master funds. The assets of master funds are allocated in Korea (61.26%), the US (22%) and emerging markets (17%).

“We make investment in advanced countries with high sovereign ratings. We are going to increase profit by allocating more funds in countries where higher inflation is expected,” a company source said.

Treasury bonds and highly-liquid assets take the lion’s share of PCA Inflation Protection Securities Investment Trust. KTBi, the basis investment of the portfolio, ranges between 20-100% in comparison with other treasury bonds because it is tied to the CPI.

The product is also classified into a variety of types by fees and expenses. For example, there is no front-end load for Class C, while Class A demands 0.5% of the payment. However, the total expense for Class C (0.7325% annually) is higher than that of Class A (0.5825%).

“Class A is desirable for mid to long-term investment, while Class C is for less-than-one-year investment because expenses may differ according to the duration,#,” an asset manager at PCA said.

Then, what should investors do with inflation-protected bond funds? The fact that they have recorded only tepid gains up until today suggests that they are not a good choice for short-term investors. An investment expert advised to add them to an existing portfolio to hedge inflationary risks.