Inflation-linked bond funds, a good buy?

I read with interest an article on inflation-linked bond funds published n Sunday Times, 20th July 2008.

With inflation escalating around the world, and much higher rates closer to home in Southeast Asia, it seems like inflation threatens emerging economies here more than the prospective of a recession. For this reason, other then the traditional oil & gas and other basic resources investment theme, inflation busting vehicles are grabbing the limelight too.

Like any hot vehicles that are created at the onset of sudden interest (bubble tea & lohan fish), which mostly under performs once the interest wanes, does inflation-linked fund belong to the same category? I will like to find out.

How Inflation-linked bonds worked

In a conventional bond, a principal is fixed at inception and the borrower promised to pay a fixed interest, typically yearly or half yearly called a coupon. For an inflation-linked fund, the principal is not fixed and actually grow at the inflation rate and the interest is calculated on the adjusted principal.

For example:

Conventional 10 year bond:
Principal: $100
Interest: 5%
=> Yearly coupon is $5 and principal recovered in 10th year is $100

If inflation rate is 5%
=> Annual return = 5%
=> Real return = 0% (5 - 5)

Inflation linked 10 year bond:
Initial Principal: $100
Interest: 5%
Inflation: 10% yearly

=> (year 1): Principal becomes $110, coupon becomes $5.50 ($110 x 5%)
=> (year 2): Principal becomes $121, coupon becomes $6.05 ($121 x 5%)
...

Since inflation rate is 10%
=> Annual return = 15%
=> Real return = 5% (15 - 10)


The idea is that whatever the inflation rate, the bond holder get the promised interest rate. If I can have access to such a bond and my aim is just to protect my wealth (I'm still trying to build some wealth to protect), I will be happy to invest in one.

How Inflation-linked funds worked

Such funds aims to protect the investor's capital in times of high inflation. Thus the primary objective is to beat the inflation; generation of real returns above the inflation is secondary. To achieve that, these funds can (not exhaustive list):

• Invest in inflation-linked bonds issued by governments in the emerging economies
• Corporate inflation-linked bonds
• Utilises sophisticated finanical instruments such as derivatives, interest-rate swops and forex contracts
  

How they actually perform

According to the article, only Fidelity Global Inflation-Linked Bond fund is available to retail investor. Hence I research a little more into it. The brochure can be downloaded here and the prospectus can be downloaded here. Since it is still relatively new, no track record is stated in the prospectus. The closest clue I can find it the following prospectus from MAS's website. The compounded annualised return is actually not very fantastic, it is about 2%.

Singapore's inflation rate (year on year changes, see my other article on inflation) normally hovers below 5% and hit an abnormal high of above 20% in 1974 and 1975. Assuming Singaore's economy stablises in the last 20 years, the annual compounded inflation rate is about 1.5%. Thus, most probably, after factoring the 0.5% mangement fee and sales charge of up to 5.25%, the fund will at most break even for investors.

Conclusion

Unless I can have access to an inflation-linked bond (which I think there's almost no possibly of losing money unless the bond issuer default), I will not consider such funds.

Inflation --- will it get worse?

Ministry of Trade and Industry Singapore had recently revised the forecasted Consumer Price Index, CPI inflation for 2008 to be between 5.0 to 6.0%, up from 4.5 to 5.5%.
(src:http://app.mti.gov.sg/data/article/13881/doc/ESS_1Q2008_PR.pdf)

Looking at recent events unfolding before me, I would think the situation would get worse before it get better.

Stocking the fire

Current inflation resulted primarily from price spikes in commodities and oil, (the latter driving up transportation cost which further pushes up the price of the former).
While many fingers are already pointing, actions to looking for scape goats (from global warming induced poor food crop harvest to hedge funds speculation in oil market) are fast and furious but actions to remedy are slow to come by.

A few factors are already fanning the fire:

Crude Oil Production

1) Under investment in oil refining and extraction capacity due to oil price languishing at low levels in the 1990's right up to 2003.
2) Political reasons that prevented increase in supply to meet rising crude demand
3) Disruptions to crude supply from producers due to various reasons, sabotage, war, freak weather etc.

Commodities supply (esp. food)

1) Growing disparity between stable food crops and biofuel food crops. It is more logical for poor farmers to grow lucrative biofuel food crops to basic food crops.
2) Rising transportation cost
3) Freak weather destroying farms and crops
4) Underfarming due to languishing low food prices for decades

In general, due to past low prices, supply is obviously not catching up with demand (especially with the rise of the emerging economies, e.g. China, India, Brazil, Russia and ASEAN nations). Whether or not the past prices are unrealistically under priced is not the issue.The issue is at those prices, it does not make economic sense to produce more or invest in the production, resulting in the current situation.

In fact, the last 2 inflation crisis are also induced by the oil spike, once in 1973, the other in 1979:

(the figures are obtained from: http://www.singstat.gov.sg/stats/themes/economy/hist/cpi.html)

Potential consequences

Slowing economic growth

The most direct consequence of surging inflation is to drive up the cost of doing business. For the small businesses, it is a matter of survival. Not only do they have to grapple with rising cost, i.e. the problem of passing on the increase to the consumers, but also falling demand for their products and services as a result. The bigger companies could ride through the crisis with falling profits, or worse with a few quarter of losses (they've done it before in previous crisis, Asian Financial crisis in 1997, 9-11 in 2001 and SARS in 2003).

In general, for businesses, there would be falling profits, scaled back investments, restructuring to cut excesses etc. For the people on the street, they would be more belt tightening, i.e. more savings and less spending (due to pay freeze, cut or even retrenchment from restructuring). The reduction in demand for goods and services becomes a self-reinforcing cycle between business and consumer. The net effect will be a slower economic growth at its best and an out right recession at its worst.


Regional Instability

Rising inflation obviously hurts the poor more than the rich. Food, transport and utility bills accounte for most of the spending for the poor. Any increase in these categories literally send their 'real' inflation rate through the roof.

To make matter worse, most of the Asian emerging economies have heavy fuel subsidies. With surging oil price, the diversion of previous government revenue required for other national uses to feed the growing subsidies is obviously not sustainable. Countries like Indonesia and Malaysia are already cutting back the fuel subsidies and it is not going to go down well with the masses, so used the subsidies. Every government in the region, rich or poor, face the increasing pressure to tackle the inflation with each increasing percentage point in CPI, any mismanagement could cost their political survival.

Silver lining

Under the free (or pseudo free) global market economy, the market ultimately sets its price when supply and demand rebalances. Any disturbance to the system will result in a short term turbulence before setting down at a new equilibrium.

While I won't go as far as the author of the following article as to celebrate (people are suffering in this part of the world):

Commodities, Oil Bubbles Are Reason to Celebrate

I do agree with him that resource bubbles (commodity and oil) wake people up, changes habits and eventually bring about conservation and greater efficiency in usage of previous resources.

Conclusion

I care less now about my portfolio (most have strong enough balance sheets and business to ride through this storm ... anyway I'm taking a long term, 10, 20 years view on them) and more about how this current surge in inflation is going to affect my life (and that of people around me). I have no doubt that the system will ultimately find a new footing and life gets back to normal, what I'm concerned is how long it will take. I'm not optimistic.