Inflation-linked bonds (ILB) were the standout asset performer last financial year, returning close to 20 per cent, but the year ahead is not expected to be so stellar as inflationary expectations ease and demand for government bonds pulls back from very high levels.
With the Australian stock market down by almost 7 per cent in 2011/12, bond prices rallied, with government bonds returning 14.3 per cent, according to the UBS Treasuries Index (all maturities).
ILBs, or linkers as they are called, performed particularly well, giving a total return of 19 per cent, according to the UBS Inflation-linked Bond Index.
Their long duration made them particularly sensitive to falls in interest rates and prices jumped.
"Since rates fell over 1.5 per cent, as a result of a dramatic fall in perceptions of growth, the value of the UBS Inflation-linked Bond Index appreciated substantially by around 14 per cent," Dr Stephen Nash, director of strategy at fixed-income broker FIIG Securities, said.
"The balance of performance has come from the real interest rate earned and the consumer price index (CPI) increases over the year."
Commonwealth Bank of Australia fixed-income strategist Philip Brown said he expected total returns on government ILBs to pull back in 2012/13 to between 5 per cent and 6 per cent, with some gains to be triggered by another 25-basis-point cut in interest rates in August.
"We're still expecting bond yields to rally, but we aren't expecting as large a rally as last year. All the ingredients are still in place. We think things will continue to get worse in Europe, so a lot of offshore investors will keep selling European bonds and buying Aussie bonds. So we expect a rally, but not to the same extent," Brown said.
JBWere head of fixed income Laurie Conheady also said he expected total returns on ILBs to ease.
"While we could have yields go a little bit lower, we think most of the gains have already been made. Also, as inflationary expectations have come down considerably, inflation isn't on the radar as much, so the demand for ILBs won't likely be as great, which will take pressure off prices," Conheady said.
He said smaller institutional investors were often put off by the very low yields on lLBs.
"We have a lot of clients who like the idea behind ILBs, but when you quote them the yield, their interest wanes. So for a lot of our clients, such as high net-worth individuals and smaller super funds, they prefer to get a higher return from a quality floating-rate corporate bond," he said.
Nash said corporate ILBs should hold the most interest for investors, as they were delivering a real yield of between 4 per cent and 5 per cent. He said he expected a return from credit ILBs of about 10 per cent this financial year.
"While not 19 per cent, this is roughly equal to the running yield of the credit ILBs, plus a little capital appreciation, as investors chase yield in a low-growth environment . Even if government yields rise further than expected, the credit ILB asset class has more than enough yield to compensate investors," he said.
