Even if you want an inflation hedge, it comes down to what the hedge is costing you, and if it’s too expensive, you shouldn’t buy it.” The $2.7 billion Electricity Industries Superannuation Scheme (EISS) recently handed its portfolio of ILBs, previously managed internally by associated manager FuturePlus, to ILB specialists Ardea Investment Management, a Challenger-backed boutique. Michael Block, general manager of investments at FuturePlus, says short-duration debt has outperformed because fears about inflation were too strong, too soon.

“Government bonds have been the best-performing asset in the past two years because there was an inflation shock – it hasn’t been as bad as what it was thought to be,” Block says. He says ILBs are an important part of a defensive portfolio for superannuation funds that should be deployed alongside other fixed interest instruments. “Every fund, directly or indirectly, is aiming to make a real return for pensioners.” This return is typically between 4 and 5 per cent above inflation, Block observes, and investors would do well to buy assets that can earn precisely this.

But it’s easier said than done. “There has never been a fund that has been able to create inflation plus 5 per cent over 20 years,” Block says. The commonly used inflation hedges, such as commodities, shares and property, have not been resistant to inflation throughout economic cycles. “They have much greater capital risk. That’s the dilemma. I don’t believe that commodities are a good inflation hedge because now we’re seeing their prices fall off a cliff. “In the past, they’ve been correlated to inflation, but that doesn’t mean this will be the case in the future.”

“What happens to them when growth is down?” Tamar Hamlyn, principal at Ardea, asks. “They are good hedges for inflation provided that growth is taking over.” And returns from cash, buoyed for much of 2007 and 2008 by high interest rates, can only ever be a “halfway reasonable” proxy for an ILB because future returns can’t be locked in, Block says. “An exact way of doing it is with ILBs. If you’re running a defined benefit or insurance fund, they’re the perfect asset because they are ‘immunising’, meaning that assets match liabilities.”

Block, formerly head of investments at the WorkCover NSW investment fund, says the current ILB offering, providing inflation plus 2.5 per cent at a decent price, is a good starting point for institutions aiming to lock in real returns for the future. But the long-held consensus that balanced portfolios in a defined contribution regime should allocate capital on a 70/30 split between equities and bonds has prevented big allocations to ILBs. “Super won’t buy a lot of ILBs, even though it should,” Block says.