The immediate threat from the global financial crisis has abated, but now investors are turning their attention to the huge amounts of government debt that have been incurred.

Around the world and in Australia, governments avoided the worst forecasts of deep recession or depression by injecting large amounts of stimulus money into the economy. This was funded by debt which will have to be repaid sometime and somehow. What will this mean for investment returns and what will be the impact on inflation?

Astute investors who have been in the game a long time know that one of the biggest threats to the long-term value of their portfolio is inflation. In recent years inflation in Australia has been benign, but a quick review of history reveals that the risk of high inflation should not be dismissed.

For investors with a long-term horizon putting some of their portfolio in assets that will retain their real (after inflation) value is a sensible idea. Inflation linked bonds are securities that provide investors with some protection against inflation.

Inflation linked bonds mitigate the risk of an inflation outbreak for an investor. Governments that are faced with a large, and difficult to service debt burden may be tempted to reduce it by allowing inflation to creep up. This will reduce the real value of the debt. They may also decide to repay the debt by printing money. This increases the money supply and in the absence of a corresponding increase in GDP generally leads to inflation.

Whilst these scenarios are unlikely to occur in the near future, investors with a long term perspective are aware that they are real risks and not unprecedented. Inflation linked bonds typically have a long period to maturity with the most recent issues maturing in 2025.

With net Australian government debt being reduced to zero prior to 2008 there was very little activity in the inflation linked bond market. Prior to September 2009 there had been no new Commonwealth government inflation linked bonds issued for six years. Now that the government is forecasting budget deficits through to 2015 a renewed funding program has been put in place. This includes both regular government bonds and inflation linked bonds.

The inflation linked bonds issued by the Commonwealth government are called Treasury Indexed Bonds (TIBs). They are issued at a nominal face value and pay interest based on a fixed coupon rate. The face value of the bond is then indexed and future interest payments calculated against the new inflation adjusted face value. For example for a TIB with an initial face value of $100 and a coupon rate of 3 per cent paid quarterly the first coupon is $0.75 (3 per cent x ¼ x $100). If inflation for the quarter is 1 per cent, the second quarterly coupon will be $0.7575 (3 per cent x ¼ x $101), and so on. At maturity the inflation adjusted face value will be repaid.

At the end of December 2009 there were $9.6 billion in TIBs on issue, representing 8 per cent of total government debt. TIBs are growing as a proportion of the federal government funding mix, and The Australian Office of Financial Management plan to keep issuing them.

Taking advantage of the increased amount of inflation linked securities on offer may be a prudent move to reduce the risk that in 20 years time your nest egg won’t buy you the lifestyle that you hoped it would.

Chris Batchelor is senior technical writer for Kaplan Professional.