Inflation- The termite in your wallet

(This appears in the recent issue of Moneylife) THE RACE AGAINST INFLATION The ideal situation for an investor is that our savings ‘grow’ in real terms. If we can invest our money without too much risk and at the same time protect its purchasing power, it would be great. In other words, if inflation is at ten percent and our savings give a return that is higher than ten percent, we have succeeded in doing this. The last three years have seen our savings getting eroded in the face of high inflation that kept eroding our purchasing power. This was primarily due to the lack of investment opportunities in fixed income at high rates. It is only in 2011 that we saw interest rates on bonds and bank deposits going up sharply. I think it is an excellent time to look at bonds and fixed deposits quickly, before interest rates start to come off. I am making a basic assumption that average annual inflation will remain at less than ten percent over the next three to five years. Is this possible? I cannot say with one hundred percent conviction, but my bet would be that inflation would remain under ten percent. This is because I expect our growth rate to slow down. This means a drop in the rate of demand for goods and services. This would help to keep inflation modest. High inflation is a worry, when our growth rate is beyond eight or nine percent is my understanding. Of course, the way the government finances are looking, there is a real risk of printing presses working overtime and pushing inflation higher. I am taking a most likely case that inflation would be just below double digits. Today, we can pick up decent double A rated paper, having three to five year maturity and giving us a yield of around twelve percent per annum. In fact, a recent issue of a NBFC had a coupon of over thirteen percent per annum. Locking in to such paper, according to me, protects our buying power. The main problem with this strategy is the vexed issue of 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 well only if you are in the zone where your tax burden is zero to around twenty percent. Why twenty and not thirty? At twenty percent tax, the post tax return on a twelve percent paper is around 9.6% and at thirty percent, 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. 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 in to equities. In such a case, I would assume that interest rates have fallen or will fall down first. Equities can be attractive only when interest rates are low. So, if interest rates fall across the board by two to three percent, then the bonds we have would appreciate in value. In which case, we can sell the bonds, say, at a gain of around two to three percent. Add to this the interest we have got, the total returns would be upward of fifteen percent. This strategy can be a loser only if equities take off from here in a big way and give us returns of over fifteen percent, 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 in to present rates of interest. Or, simply that inflation keeps going up and interest rates stagnate. In such a case, we would have lost out anyways. Maybe then gold or commodities would give the returns, but I wonder how many of us are competent to park our investments in either. 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 a tough ask. I only hope that the time does not come when we get in to a situation of job losses across the private sector.