In exchange for buying an indexed annuity bond (IAB) with an up-front, lump-sum payment, you then receive a cashflow comprising both principal and interest until the maturity date of the bond.
As a result of the payment stream consisting of principal and interest, these bonds are ‘annuity like’ but the payment is indexed to the Consumer Price Index. That means IABs also offer protection against inflation, as inflation increases over time, so will the cashflows you receive.
The principal repayment schedule is calculated in essentially the same way as a conventional house mortgage. In the absence of inflation, each payment would be equal, consisting of part principal and part interest, just like a mortgage. This amount is also referred to as the base payment or ‘base annuity’. The base payments are indexed (by inflation) over the life of the asset, resulting in a inflation protected payment over the life of the bond.
Because the quarterly IAB payment is made up of principal and interest, the payment is higher than that of a CIB (which only receives a repayment of interest quarterly). This is a key for investors when deciding whether their investment needs are better suited to an IAB or a CIB. Investors more concerned with protecting their capital from inflation may prefer to invest in CIBs, whilst investors more concerned with receiving higher, inflation protected cashflow streams may prefer to invest in IABs.
An annuity is a series of regular future cashflows, due and payable to the investor in return for the purchase price paid.
Key IAB strengths
As IABs are indexed to the CPI, investors cash flows are protected against inflation
Tradeable, just like other fixed income securities
Long terms to maturity which help lock in returns
Can add diversification to your portfolio
Paying real yields over and above inflation of CPI + 3%
Low minimum investments given some bonds have repaid significant principal.