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Tom Holland

At first glance, the Hong Kong government's latest wheeze - issuing HK$10 billion worth of inflation-linked bonds - looks like a jolly good idea.
It's not that the government needs the funds. With more than HK$1 trillion stashed away in the exchange fund over and above what's needed to back the Hong Kong dollar peg, the government is up to its eyeballs in money it doesn't know what to do with.
But by issuing the bonds - dubbed ibonds - the government hopes to win brownie points for protecting the city's population against rising inflation.
On the surface it seems a good plan. The three-year bonds will pay a twice-yearly coupon equal to the average rate of inflation over the previous six months. And if inflation drops, they will pay out at a rate of at least 1 per cent.
To Hongkongers earning at most 0.5 per cent interest on their deposit accounts and seeing the spending power of their savings whittled away by inflation currently running at 5.2 per cent, that might sound an enticing deal.
At the very least, the value of their savings will be protected, and if inflation falls they will still be left with a 1 per cent return, which is more than they can earn right now on a deposit account.
But dig deeper and the ibond offer begins to look a little less attractive than it appears at first.
The big risk for investors is that inflation could fall, leaving them out of pocket. That might not sound likely, given all the chatter about mounting inflation pressures.
But it is important to remember that inflation in Hong Kong is driven primarily by rental costs. 
The two biggest items in the government's consumer price index basket are housing, which means residential rents, and meals away from home, whose prices are driven largely by the commercial rents paid by restaurants.
Over the first five months of the year, increases in the costs of housing and of eating out were responsible for more than half of the total rise in Hong Kong's consumer prices. And Hong Kong's history teaches us that when it comes to rents, what goes up can fall with startling rapidity.
The first chart (above)  shows the residential rent index compiled by the Hong Kong government. As you can see, between October 1997 and November 1998, rents collapsed by 28 per cent. Once again, between July 2008 and March the following year, they plunged by 23 per cent.
Now take a look at the second chart, which shows Hong Kong's consumer inflation rate. On both occasions, in 1997 and 2008, that rents collapsed, the inflation rate also collapsed, with the city plunged into deflation both times.
It could happen again. 
With the Hong Kong government trying to cool the city's property market, the influx of mainland funds evaporating and interest rates on new mortgages rising as credit demand picks up, some analysts are now forecasting a 30 per cent slide in home prices by the end of next year.
If prices do fall to such an extent, rents will soon follow, and Hong Kong's inflation rate will plummet. 
In little more than a year, Hong Kong could be back in deflation.
That would still leave holders of the government's inflation-linked bonds earning a 1 per cent yield, which you can argue is better than a kick in teeth.
But a kick in the teeth is pretty much what it could turn out to be.
Futures prices indicate the market expects the US Federal Reserve to increase interest rates by almost 2 percentage points over the three-year life span of Hong Kong's ibonds.
That would push Hong Kong dollar time deposit rates up to around 2.5 per cent, which would mean ibond holders earning just  1 per cent would lose out badly.
Of course, they could simply sell their bonds and put the money on deposit. 
But given the ibonds' dismal coupon, they would hardly get an attractive price in the market.
In all probability, they would take a nasty capital loss on their investment. And to add insult to injury, they would take a hit from the abysmal liquidity in the Hong Kong dollar bond market, where bid-offer spreads can be as wide as 2 per cent.
So, the government's inflation-linked bonds may not turn out to be quite the low-risk investment they seem.
If you are a retiree who is not going to touch your time deposits for three years and who believes inflation will continue to rise over that period, then fine, ibonds make sense.
But if you are worried the Hong Kong property market is primed for a reversal, or that the mainland economy is heading for a bumpy landing, which will reduce global inflation pressures, then don't touch them with a bargepole.




HK ibonds not the low-risk investment they appear