They say time
and tide wait for none. But what if we tell you that inflation also is
something that doesn’t wait for anyone? In India, inflation has been on a
consistent rise for decades. And so is it in other countries as well. However,
let’s focus on India for now.
Of course, the government has done a commendable job by maintaining a more or less constant value (with slight deviations). However, in the long run, you will need inflation-proof investments to battle inflation out effectively and stay at a plus value. Most consider Fixed Deposits (FDs) an option to do that. But let’s see if it works, or as an investor, will you have to think a little differently and embrace other investment options.
Combating Inflations with Conventional FDs – Does That Work?
In India, investing in FDs is traditional. And that’s for a reason. While contributing to portfolio diversification, they offer steady income and help preserve the capital amount. Nevertheless, when it comes to inflation, FDs don’t prove as useful. Why and how?
Let’s say you invest Rs. 1,00,000 for five years in an FD offering a 6.5 per cent interest rate. The interest you accumulate on your amount after five years will be approximately Rs. 38,000. So, you’d be happy to earn nearly 40k on your investment doing nothing but retaining it in an FD account! But the story doesn’t end here. It begins from here.
If the inflation rate that year is 7 per cent, you will end up losing more money than you earn. Add to it the taxes you pay on your interest earned, your earnings will further plunge! In other words, you lose money investing in an FD when the inflation tide is against you! So, when it comes to inflation, you cannot rely on FDs alone. You need a more remunerative investment that helps you deal with the rising prices. Can inflation-indexed bonds prove a potential alternative, given the situation? Let’s see.
Thinking Differently with Inflation-Indexed Bonds
So, what is an inflation-indexed bond? It is a fixed-income security with principal and interest payments linked to the existing inflation rate. So, the value of these bonds increases with a rise in inflation. Thus, it fundamentally ensures that your returns stay aligned with the rising inflation. Let’s overview it with the below example.
Let’s say you invest Rs. 5,000 in a 10-year maturity bond with a 3 per cent interest rate.
Now, if the
inflation rate is 4 per cent when the issuer issues the bond, you receive an
annual interest payment of Rs. 156 in the first year.
In the second year, let’s say the inflation rate increases by 5 per cent. So, you receive an annual interest payment of approximately Rs. 163. The coupon rate will remain above 3 per cent inflation across the bond’s maturity.
The process continues until the bond’s maturity to help you keep up with the inflation rate. If the inflation rate stays lower than the fixed interest rate, the total interest would remain lower than the fixed rate. However, if the inflation rate is higher than the fixed interest rate, you would receive a higher total interest payment. Thus, in the latter situation, the bond would help you keep protected from rising inflation.
Pros and Cons of an Inflation-Indexed Bond
Fundamentally, inflation-indexed bonds safeguard you from inflation increments by adjusting your returns according to the rise. Additionally, they have various other benefits associated with them. So, let’s look at the advantages of inflation-indexed bonds initially and then also overview the flip side of the coin.
Advantages of Inflation-Indexed Bonds
Some pros of inflation-indexed bonds include the following.
- Inflation Protection: The most significant advantage of inflation-indexed bonds is that they adjust the bond’s principal value with the inflation. Thus, they ensure that the investment’s real purchasing power is maintained. The feature or fundamental nature of these bonds makes them a proposition, especially during spells of high inflation.
- Predictable Income: Investors earn predictable real returns. Hence, investor segments, including retired people and other investors looking to create stable income streams and predictable income can keep up with the inflation rate.
- Portfolio Diversification: Another crucial advantage of inflation-indexed bonds is that they help investors diversify their portfolio by providing a hedge against inflation which may not correlate with conventional bonds or stocks.
- Secure Investment: Usually, it is governments or highly creditworthy organisations that issue inflation-indexed bonds. Thus, they are considered a safer investment.
Disadvantages of Inflation-Indexed Bonds
Inflation-indexed bonds have some disadvantages as well, about which you, as an investor, should be aware to make an informed decision.
- Lower Nominal Yields: These bonds often have nominal yields lower than their conventional counterparts with similar maturities. That can negatively affect the overall returns, particularly during periods when the inflation rate is low.
- Liquidity Risk: These bonds may have a liquidity lower than conventional bonds. Hence, they aren’t as suitable for investors who want to sell their bonds quickly.
- Interest Rate Risk: Inflation-linked bonds adjust the principal value with inflation. However, the interest payments remain dependent on the principal value. Hence, they are sensitive to real interest rate changes. Accordingly, an increase in the real interest rates reduces the future cash flow value of the bond. It results in capital losses for investors who look to sell their bonds before maturity.
- Complex Working: Inflation-linked bonds have a complicated working. Comprehending how inflation adjustments affect the value and cash flows of the bonds can prove overwhelming for some investors. Hence, many investors refrain from investing in inflation-indexed bonds.
Stay Inflation-Ready with Inflation-Linked Bonds – Sign Up with AltiFi Now!
Inflation will grow with time. No time-travel machine can transport us back to prices and inflation rates from the 19th century. While it is agreed that an individual cannot control inflation, you can battle it out and stay prepared for future flare-ups with intelligent inflation-linked bonds. Remember, inflation-indexed bonds aren’t a surefire way of dealing with inflation, as they carry all the risks that other bonds carry. However, it is about thickening your chances of survival with more meaningful investments.
Sign up with AltiFi if you are looking to invest in bonds.
Disclaimer: The contents of this article should not be construed as tax or financial advice. Readers should seek advice from their tax or financial advisor before making any investment decision.