An almost guaranteed loss - in real terms

The Hong Kong government has announced that it will press ahead with the issue of HK$10 billion of inflation linked bonds. In spite of going on a spending binge (unjustifiable increases in already bloated civil servant salaries, new government offices and, most likely, sticking the taxpayers with the cost of a third runway etc etc), the government does not need the money - it is sitting on financial reserves which are enormous however you measure them.

The bonds will pay interest at the higher of the rate of inflation (as measured by the CPI) or 1% pa every six months. Maturity is in 2014 (three year term). There will be no adjustment to the principal value of the bonds.

Unless inflation is below 1%, the bonds will guarantee a loss to investors in real terms because:

1. there will be a fee payable on application (expected to be 0.15%);

2. the interest payments will be at least six months in arrears;

3. the banks will charge a fee on each interest payment and on repayment of principal on maturity.

Depending on the amount invested and the CPI, the cumulative effect of items 1-3 above could be about 1% a year. Viewed in isolation, the bonds do not represent good value. IMHO, this remains true, even with the downside protection offered by the 1% floor in the event that we have very low inflation or even deflation.

However, I'll be applying for whatever I can get. With inflation currently above 4% and expected to exceed 5% this year, the yield is much better than I can get on either term deposits or other HKD/USD bonds with a similar maturity. I intend to keep about 24 months' worth of expenses in cash or near cash form once I retire. HKD bonds issued by the HKSAR government with a maturity of three years (less the interval between issuance and my retirement date) will be a much better option for the cash/near cash part of the private portfolio than bank deposits with their negligible yields.

The issue will be the fact that only HKD10 billion will be issued - getting a reasonable allocation may be difficult.