IN A NUTSHELL: By investing in inflation-linked bonds, investors can protect the buying power of their money.
“Inflation is the biggest enemy of savings.” You’ve probably heard something along this line before. As well as “keep your friends close, and your enemies closer.”
The best way to beat inflation is by understanding this enemy. In short, inflation is the general increase in the price of goods and services over time. That feeling that every time you go to the shop, your basket of regular groceries is more expensive, that’s inflation.
Let’s explain
Over time, inflation decreases and sometimes completely wipes out the buying power of your money. In 1970, you could buy all the above for R1.15, whereas today you’re lucky if you can buy one Wilson toffee!
One way to safeguard the buying power of your money is by investing in inflation-linked bonds.
What is a bond? Bonds, debt instruments, and fixed-income refer to more or less the same thing – it’s when you invest in debt.
Governments and companies raise money for expansion and development by issuing bonds. When you buy a bond, you are lending your money. In return, they pay you regular interest and the full amount you invested (the principal) at the end of the agreed period.
And an inflation-linked bond (ILB)? Regular bonds pay interest at a fixed rate, say 8%. ILB’s principal amount and the interest payments are adjusted along with the inflation rate.
Let’s explain
Lebo invests R10 000 in a regular bond with a fixed rate of 8%.
Raymond invests R10 000 in an ILB with a fixed rate of 5.5%.
The inflation rate is 3 %.
At the end of the year Lebo receives an interest payment of R800 in his regular bank account.
R10 000 x 8% = R800
But remember our enemy called inflation? The buying power of his principal amount (R10 000) left in the bond is now less; the real value is only R9700. (We deduct the 3% inflation).
Raymond’s principal amount in the ILB is:
1 First adjusted for inflation: R10 000 + 3% = R10 300
2 And he earns 5.5% interest: R10 300 x 5.5% = R566,50 which is paid into his bank account.
The buying power of Raymond’s principal amount (R10 300) is the same as at the beginning of the year.
What trustees should know
One of the key responsibilities of a retirement fund is to grow members’ savings so that they can retire comfortably – they should be able to afford a burger in 20 years.
Inflation-linked bonds (ILBs) are one way to do just that. ILBs are especially valuable to defined-benefit funds, like the GEPF, which promise members pensions linked to inflation.
ILBs are not about chasing high returns, but about protecting the real value of the fund’s money and matching inflation-linked promises to members.
Let’s explain:
Retirement Fund A invests in inflation-linked bonds (ILBs) and shares on the stock exchange. Retirement Fund B invests only in shares and cash.
Over three years, inflation stays high at about 6%. Because of this, companies face higher costs and cut back on expansion and jobs. The stock exchange performs poorly, and the value of both funds’ shares drops.
However, the ILBs in Fund A’s portfolio increase in value because they are linked to inflation — both their capital value and interest payments rise. The growth from the ILBs helps offset the losses from shares.
As a result, Fund A’s overall portfolio stays more balanced, while Fund B’s portfolio, which lacks ILBs, suffers a much larger decline.
Further reading
What is an asset class?
Source
Colourfield: The Perfect Storm
PU Prime: Smart Investor’s Guide To Inflation-Linked Bonds And Opportunities
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