Feeling Anxious About Inflation? Tame the Heat with the Right Bond Strategy
Inflation is something that worries everyone. Believe it or not, even the richest of all dread the rising inflation rates! So, feeling anxious about it is usual. In India, inflation has long been a hot political and economic issue. The government has been able to control it significantly in recent years. However, it would be unrealistic to expect it to remain constant throughout and at the same time, enjoy historic economic growth.
India’s current inflation rate stands at 5.69 per cent (as of December 2023), which marks a 1.6 per cent decline compared to 2022, when it was 6.7 per cent. Although that’s great news for now, in the long run, you should be prepared to tackle the rising inflation mercury with the right investment strategy. Are bond investments one? Let’s find it out.
The Relation Between Inflation and Economic Growth
India is one of the fastest-growing economies in the world and is also projected to soon become one of the top five. Nonetheless, what’s worth remembering here is that we live in a growing economy. We offer a flourishing environment for every business, no matter IT, healthcare, manufacturing or hospitality. There’s something for everyone in India.
Inflation rates and gross demand product (GDP) (a significant part of every economy) are closely related. Inflation can rise with GDP growth driven by augmented demand or a drop in supply. A balanced relationship can help prevent a considerable rise in inflation.
A growing GDP with a trivial increase in the associated inflation indicates a healthy economy and a progressive nation. It refers to companies producing goods, earning profits, employing people and paying wages regularly. On the other hand, it also signifies a considerable increase in demand and consumer spending capacity.
While a rise in the GDP proves exciting, it is worth noting that excessive GDP growth can shoot the inflation rate, impact businesses and cause consumer spending to plummet.
Although we are part of the macroeconomic environment, individually, we cannot do much to control it. Besides, a country’s economy also depends on the global economic weather. Economic down waves or geopolitical vagaries across other countries can impact our economy and inflation rates as well. So, how do you keep up with the inflation fluctuations or increments at your level? Of course, it is through smart and futuristic investments. Let’s examine a few of them, including bonds in this regard.
Does Being Conventional Work Amidst Rising Inflation?
Even today, a significant chunk of the Indian investor population believes in investing in conventional avenues. The reasons are obvious – stability, security and reliability. We wouldn’t say they are wrong. Everyone has unique investment and wealth-generation objectives. Thus, if conventional options like fixed deposits work for them, so be it. But on the one hand, where our economy grapples with rising inflation rates, on the other, can fixed deposits help combat inflation – let alone generate wealth? Let’s see.
Banks and other financial institutions usually offer an interest rate of 8 per cent interest rate on a five-year fixed deposit. Great, isn’t it? Earning a staggering eight per cent over the principal can excite many. So, if you invest Rs. 1,00,000, you’d earn Rs. 8,000 doing nothing but only depositing money.
However, are those 8 per cent returns good enough to outpace or even match the pace of inflation? Apparently, yes. But if you delve into the technicalities of it, the answer will be a resounding no. It is because you haven’t accounted for the declining value of the money due to inflation and taxation. As for the latter, interest earned on a fixed deposit is taxable. So, when the tax gets deducted from the interest, the returns you earn would further drop. Thus, the return value will end up being less than the inflation rate.
Let’s look at it through an example. So, let’s say, you’ve earned Rs. 8,000 over a deposit of Rs. 1,00,000. As the deposit holder, if you are in the 30 per cent slab, you would need to pay a tax of Rs. 2,400 INR deposit holder is in the slab of 30%, thus reducing the net interest to Rs. 5,600 INR. So, the net interest rate is only 5.6 per cent against an inflation rate of 5.69 per cent. So, is your earnings outscoring inflation? You may do the math!
Beating Inflation with a Long-Term Investment Strategy - Are Bonds Bankable Enough?
With economic growth, inflation, although at varying rates, is inevitable. So, let’s talk about solutions instead of problems.
Inflation grows over a period. In unstable or floundering economies, it might skyrocket at any given point. Fortunately, in a stable economy like India, rising inflation rates at least give us the time to think, revisit our investment strategies and realign them with the inflation rate. Again, it also offers investment avenues that can help investors keep up with the growing inflation graph. Bonds are one of them. But are they good enough? And if so, what type of bonds can prove potentially remunerative to stay afloat?
- Floating Rate Bonds
Floating bonds adjust their interest rates periodically and therefore, present a more agile and flexible approach to the dynamic economic environment of a country. Thus, investing in floating rate bonds ensures that your returns remain aligned with the changing market conditions, serving as a hedge against the potential economic damage inflation may cause to your investments and returns.
- Inflation-Linked Bonds
Another option for investors looking to reduce the impact of inflation, if not fully neutralize it, is inflation-linked bonds. For example, one may invest in RBI’s Inflation-Indexed Bonds (IIBs) to battle inflation out. These bonds align their both interest payments and principal according to the Consumer Price Index (CPI). Thus, by aligning with inflation rates, IIBs help preserve your investment’s real value. They also provide a reliable investment for everyone looking for portfolio protection against inflation.
- Short-Term Bonds
Short-term bonds are another effective way to decrease inflation sensitivity. These bonds have shorter maturity periods. It means their interest rates remain less affected by long-term inflation trends. Thus, through more frequent resets per market conditions, short-term bonds prove more adaptive against inflation uncertainties.
- High-Yield Bonds
High-yield bonds like corporate bonds or non-convertible debentures (NCDs) can also prove a remunerative investment strategy. These bonds offer higher interest rates that can compensate for the increased default risk and inflation rise. Although they carry a higher degree of default risk, they offer potentially higher returns. Hence, they prove more appealing to investors who intend to balance risk and reward while aiming for a steady income despite boiling inflation.
Final Words
Bonds can help protect your investments against inflation. However, what matters is the right bond strategy i.e., the bond type and the organization in which you invest. You may want to look for bonds falling in any of the above categories to potentially protect your investments against rising inflation in the long run. Nevertheless, the performance of the organizations offering these bond options and the overall economic environment in the future will also play a vital role.
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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.