• The Fixed Income

Debt market and making real money!

Updated: Sep 20, 2020

A big enemy of the value of money is inflation. It is like cancer that chews into the ability of money to represent its true character – represent value and wealth, to purchase goods and services. Inflation has an evil twin – taxation, of which Benjamin Franklin wrote in 1789,

…in this world, nothing can be said to be certain, except death and taxes.

Any return that an investor earns that will add to her wealth that is in excess of the damage of the inflation and tax twins is really hers. In a way, this is the real rate of return, the money that lines the pocket.

Former RBI Governor Raghuram Rajan spoke of the purchasing power of money in terms of dosa (a popular South Indian crepe). The clip is popular on YouTube and is spoken of as Dosanomics.

Money is worth what it can buy over extended periods of time. Erosion of this value even after earning interest is harmful to all who hold money and investments, in particular to retired folk. Put simply, a fixed deposit earning 6% a year earns about 4% after-tax, at the highest personal slab. When impacted by inflation at say 6%, the rate of real return earned is a negative 2%. Yes, after-tax and inflation there is a loss in the value of money such that after a year of a deposit of Rs. 100 at 6%, only Rs. 98 are returned to the investor.

Just deducting the inflation from the rate of return is an approximation that suits the layperson. A student of finance would use the proper formula to find out the real rate of return as:

Real rate of return = {(1+rate of return)/(1+rate of inflation)} – 1

Using this in a scenario of 6% post-tax interest and 5% inflation,

The real rate of return = (1.06/1.05) -1 = 0.009524, or 0.95%

Even getting a meager positive real return involves pushing for a return or interest rate that is higher than inflation, after taxes, involving a hunt for better-performing investments. Better performing investments compared to the traditional bank fixed deposits need careful analysis for the additional risk taken to provide the higher returns. Bond experts such as Tipsons are well placed to help investors match the risk and returns of bonds to their risk profiles.

The matchless investment available to resident Indians is the Public Provident Fund which has an upper investment limit of Rs. 1,50,000 a year and should be our starting point for the quest towards superior post-tax positive real rate of return. (Though PPF is a no-commission product for us, we advocate it as an important deployment of our client’s money. Its limitations are the investment cap and unavailability to HUF, NRI, and non-individuals).

Modern Monetary Theory (MMT) which advocates flooding the economies with abundant, cheap money called Quantitative Easing and its partner-in-crime NIRP (Negative Interest Rate Policy) is creating a desperate need for managing risk not just of investments, but also of the depreciation that our monetary assets will face. Locking into more productive bonds early may be part of a good investment plan.

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