What is the price of obtaining a guaranteed return? More correctly, what will it cost you to buy a guaranteed return? We all want a great tax-free return with no risk but the reality is that every investment involves some element of risk and tax – well, we all know the old saw about death and taxes… This post is a highly specific look at an investment with a blue-chip guarantee, and the price/cost that must be accepted when you buy it.

Before reading on, please note the Great Disclaimer! Nothing in this post or on this site is to be considered personal financial advice. It is general advice only, and really isn’t even that! It’s my musings on money and the issues surrounding financial planning. You must not take anything on this site as a recommendation to buy or sell or hold anything nor as a suggestion that one strategy is better than another for you. Personal financial advice can only be provided under highly specific conditions, and this site does not meet them. For more detail, see ASIC’s moneysmart site.

Please also see my disclaimers and notes on the specific investment, which are shown at the end of this post.

Now, back to the point at hand… musing about guaranteed returns.

Guaranteed Returns for 17 years!

How would you feel about an investment where :

• you will receive a quarterly income at a fixed rate for the next 17 years..?
• your capital will be adjusted up (and only up!) to account for inflation from the time that you bought it through to its maturity in 17 years’ time, and to top it off …
• this investment is guaranteed by the Australian Government. 

What is this investment?

It’s an Australian Government Bond, which has traditionally been available through the Reserve Bank of Australia’s “small parcels facility”. This egalitarian shop has allowed the average investor to purchase some of the risk/return qualities of a government bond for as little as $1,000. Government bonds are usually be out of reach for the average investor, as the minimum bid cost to buy such a bond directly is $1,000,000 (and only in parcels of $1,000,000 as well!), an amount that is well beyond the means of most people. The small parcels facility is therefore a government initiative to share the benefits of government bonds more widely.

This small parcels facility has recently been closed, and investors must now purchase this investment through the Australian Stock Exchange (“ASX”), via Exchange Traded Funds (known as “ETF’s”). In effect, the government bonds are now available as a series of managed funds – but you buy a specific bond with each exchange traded fund rather than investing into a diversified parcel of bonds as you would if you bought into a ‘standard’ fixed interest managed fund.

Guaranteed returns – the pro’s

The specific exchange traded fund has an ASX code of GSIQ30.ASX. It offers exposure to the underlying security of a Treasury Capital Indexed Bond, number 408. It pays a “coupon” or interest rate of 2.5%per annum in quarterly installments right up until its maturity on the 20th September 2030. Guaranteed returns!

Most importantly, that interest rate is adjusted for changes in inflation. In other words, if inflation increases the cost of goods and reduces the purchasing power of yesterdays dollar then your next income payment is likely to be higher. In other words, this is an income-based investment that includes a guarantee to help cushion the impact of inflation.

For example, the dividend payable on the 20th June this year was 67 cents. The dividend payable on the 20th September has been announced to be 67.4375c. In extremely broad terms, the dividend has been increased by inflation at an annual rate of something close to 2.4%. Now that is something that your average term deposit isn’t going to offer you!

Guaranteed returns – the con’s

There’s always a negative, isn’t there? One negative is fees and costs. If you were to place your money into a standard bank term deposit then you’d expect to receive a net rate of return with no additional fees (those fees are obviously enough built into the interest rate of the term deposit). If you buy and sell on the stock exchange then you are going to pay brokerage to buy and brokerage to sell that exchange traded fund investment. The actual level of brokerage cost will differ depending on your particular broker arrangements but regardless, there is a cost.

Another negative is that the income is paid on a ‘notional’ capital amount. In effect, that notional figure means that the actual rate of return you will achieve will be unlikely to reflect an exact 2.5%. It could be higher or lower depending upon the price you pay for the bond exposure.

The other negative is the possibility of deflation – in other words a drop in prices (as measured by the Consumer Price Index “CPI”). If prices actually retreat then the income payment will be reduced, and the capital you can expect at maturity. There is a “bottom line” though, as the government guarantees the underlying bond would always have a value at least equal to its original issue value. There’s still room for a fall in values, and therefore a capital loss – but the extent of the possible fall is reduced by this government minimum guarantee.

The big bogey in the room for a long term fixed investment though, is the possibility of an increase in long term interest rates. If long term interest rates rise then the value of your lower interest rate security will fall in value as you will be receiving less than the going interest rate every year right up to maturity. The further away that maturity date, the larger the likely drop in value of your fixed interest investment.

Being a listed investment, you will only ever receive the price that someone is prepared to pay you on the day. If there aren’t any takers then you may find you cannot sell your investment at all or you may have to sell it for less than its correct worth at the time. This particular risk is moderated somewhat by the structure of the exchange traded fund, and the presence of “market makers” who will stand in the market to buy or sell. Some risks are minimal but it doesn’t mean that they do not exist.

How does the income compare?

Well, at the moment a 2.5% income doesn’t look all that flash. At the current pricing and declared interest rate, you will be earning around 2.37% in a full year. However, you must remember that todays’ income is guaranteed to be indexed to inflation in the future.

This compares with a current “Big 4” bank 12 month term deposit return of about 3.4%, and a cash rate of around 2.0-2.5%.

Current online savings account rates are up to 4% but the large bank average is less than 3% (note that i am completely ignoring the “promotional rates” which can be up to 4.77% from the NAB offshoot “UBank” at the moment).

Listed property trusts are running at about 5.17% yield currently, while an investment into the top 200 shares via the S&P/ASX200 Index is yielding around 3.96% + franking credits at the moment.

Guaranteed returns – but what about capital?

We can track such issues by simply looking at the pricing being offered for this Treasury Index Bond exchange traded fund since it was listed on the Australian Stock Exchange around the 21st May 2013.

Let’s work out this example in a bit more detail…

If you had $100,000 to invest back on the 21st May 2013, you could have purchased 753 units at a price of $132.63 per unit. Add in a highly discounted brokerage rate of 0.11% and you have now invested $99,980.25.

You would have received $506.32 on the 20th June and will receive a further  $507.80 on the 20th September. Good, solid, inflation-adjusted income!

However, if you were to sell your units today, you would have received $113.93 per unit – ie, $85,789.29.

To receive your inflation-protected income with a guaranteed maturity value in 17 years time, you have put yourself into the position whereby you would have lost $13,271.21 if you were forced to sell today.

i have gone through this in some detail to share with you the angst of professional fund managers at the moment – how do they obtain a secure long-term income without compromising their portfolio values? We’re not going to go through the answers to that today but hopefully the above maths gives you some idea of the background to my earlier posts warning of the issues surrounding fixed income investments and traditional attitudes to them.

What is the potential for interest rate reductions?

Simply put – not much. Long term interest rates globally have been pushed down by the actions of central banks in the USA, UK, Europe and Japan. The volume of dollars has been enormous and unprecedented historically. Therefore, it is reasonable to expect that upon money printing ending, the long term rates will rise to whatever constitutes “normal”.

Here is a look at the USA long term rates (the 30 year government bond interest rate or ‘yield’).

You can see that any sort of return to past averages could further impact the value of your long term income security. Having said that, predicting interest rates is a mug’s game, and experts routinely get any such predictions wrong, so it all comes back to the balance up of risk and return.

 Every guarantee has a cost!

So we end with the lesson behind this post. Every guarantee has a cost because someone, somewhere, is accepting less of something in order to provide that guarantee. In this case, the long term guaranteed nature of the investment provides some certainty against inflation but it doesn’t really help if deflation takes hold, nor does it help if the interest rates were to spike up.

Personally, i like the characteristics behind this kind of investment. Inflation being triggered somewhere is a definite risk when money printing stops, and an investment that offers protection over the longer term can be very helpful from a portfolio sense. However, the risks to such investments at the moment are very real. In effect, a traditionally defensive asset can be expected to show volatility characteristics similar to a share investment – and that is a danger to those not completely familiar with investments in this area.

 Notes and Disclaimers

This post is not suggestion you buy, sell or hold an investment in the particular listed exchange-traded-fund which offers exposure to Treasury Indexed Bonds. There is a great deal of information and context about this investment that it is not possible to cover in a brief post such as this. From a financial planner point of view, this investment would be seen as being a “defensive” asset by virtue of its asset class (being fixed interest, with guaranteed capital repayment at maturity) but higher risk by virtue of its lack of diversity, the issue of timing your purchase, the possibility of loss of capital if long term rates rise and you are forced to sell and numerous other points. In other words, there is absolutely no way that a broad statement can be made that would provide an individual with sufficient data on which to make an informed decision on whether this particular investment is appropriate for them.

The point of this site is to share my musings on matters financial. This will from time-to-time involve looking at specific investments but it should always be understood that in such circumstances i am simply selecting an investment to illustrate a point – i have absolutely NO intention of making specific product recommendations on this site.