Fixed income: Beating inflation

The ideal situation for investors would be one in which their savings ‘grow’ in real terms. If we can invest our money without too much risk and, simultaneously, protect its purchasing power, it would be great. If inflation is at 10% and our savings give a return that is higher than that, we would have succeeded in achieving this.

The past three years have seen our savings getting eroded in the face of high inflation. This was primarily due to the lack of investment opportunities in fixed income at high rates. It was only in 2011 that we saw interest rates on bonds and bank deposits go up sharply. I think this is an excellent time to look at bonds and fixed deposits quickly, before interest rates start to come off.

I am assuming that average annual inflation will remain at less than 10% over the next three to five years. I expect our growth rate to slow down, leading to a drop in demand and price growth. Of course, since the government finances are weak, there is a risk of printing presses working overtime and pushing inflation higher.

Today, we can pick up decent double-A-rated paper, with a three- to five-year maturity, giving a yield of around 12%pa (per annum). In fact, a recent issue of an NBFC (non-banking financial company) had a coupon rate of over 13%pa. Locking into such paper, according to me, protects our buying power.

The main problem with this strategy is taxation. Interest on fixed-income instruments is fully taxable. Of course, when we put money in bonds that are ‘listed’ on the exchanges, there is no deduction of tax at source. So, this strategy can work best only if your tax burden is 0%-20%. At 20% tax, the post-tax return on a 12% paper is around 9.6%; at 30%, it would be 8.4%. Only if inflation stays below 8.4%, would there be any ‘real’ return. I am also assuming that over the next couple of years, equities are not going to give great returns. Even if they give a couple of percentage points higher, I do not mind locking my money for fixed returns. The risk-reward ratio for investing in equity is still not very tempting vis-à-vis fixed income.

Let us for a moment assume that things are going to get very good in about a year or so and we would like to put some of the money into equities. In such a case, I would assume that interest rates have fallen or will fall first. Equities can be attractive only when interest rates are low. So, if interest rates fall across the board by 2%-3%, the bonds we have would appreciate in value. In which case, we can sell bonds, say, at a gain of around 2%-3%. Add to this the interest we have got, the total returns would be upward of 15%. This strategy can be a loser only if equities take off from here in a big way and give us returns of over 15%, year-on-year.

The other situation is that inflation continues to remain high and interest rates keep going up. If both happen, then we lose out since we have locked into the present rates of interest. Or simply, if inflation keeps going up and interest rates stagnate, we would have lost out anyway. Maybe then gold or commodities would give the returns, but I wonder how many of us are competent to park our investments in either of these asset classes. Yes, all of us do have gold as a part of our core assets, but we do not generally keep buying and selling gold.

The other thing in these times is to keep an eye on our borrowings (home loans, etc). If inflation remains high, it makes sense not to prepay any of our loans. I only hope that most of us have incomes which also rise in relation to inflation. In a slowing economy this is tough.
 

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