A little while ago, it was hard not to notice the smirk on the face of one of my cycling mates. His body language made it clear that he had something to share.
I resisted the temptation to ask as I assumed he most probably wanted to show off his new personal best time on the tricky piece of single track where, not so long ago, my ego was severely bruised.
Reading my mind – “no”, he uttered – rather, he had finally convinced his aging mother that it was time to let go of her 1980’s Volkswagen Passat. Even better, he managed to sell it for an amount close to the approximate R8 500 his parents had forked out way back then. “Not a bad trade, right?” His eyes lit up as he searched for acknowledgment.
Needless to say, I was momentarily stunned into a morbid silence by the breaking news. How to respond. Do I simply give him a pat on the back and change the topic or do I help the poor man out of his unbeknown misery? While considering my response, the childlike expression on his face instantly reminded me of all those times he raced ahead of me through the tightest of switchbacks with annoying ease, waiting at the bottom for the old snail. It struck me then that it was my turn to shine. “Well done dude, so what are the plans with the proceeds of this well-timed sale?” Not bothering to wait for the reply, my fleeting lack of emotional intelligence prompted me to spew the next question, “No wait, I have an idea, why not buy that entry-level mountain bike for your 12-year old!”
The point of this lighthearted scenario is that it is a real-life example of the disastrous impact of inflation on our purchasing power. In the subject’s mother’s case, for the same nominal rand amount, she dropped in status from driving a fairly sophisticated vehicle (for its time) to the option of buying an entry-level bicycle for her grandchild at the same price. The fact that this happened over a 30-year period does not change the basic principle. No wonder the South African Reserve Bank, not unlike most other central banks, keeps reminding us, when it deems it fit to administer the bitter medicine of an interest rate hike, that an important part of its mandate is to bring about relative price stability, i.e. to fight inflation.
What are the alternatives?
Financial markets offer a number of potential inflation-beating alternatives. In our world of interest rate bearing investments, the best option to match inflation is an investment in inflation-linked bonds. The principle is simple and eloquent. To explain, one needs to cover some basics.
Firstly, let’s revisit the workings of a nominal bond. In doing so, we assume that the bond is held until maturity, thus not traded in the secondary market. The capital you lend to the borrower, by way of example we will use the RSA government, is termed the principal and serves as the face value of the instrument. In the wholesale market, these bonds are sold in denominations of R1 million. This value remains constant over the life of the bond, and unless the issuer defaults, government will return your initial capital outlay on the maturity date of the bond. In return, as an investor, you are paid a predetermined fixed interest rate on this loan which is reflected as the coupon rate. Therefore, both principal and coupon rates are fixed. The benefit of this is that you know exactly what return you will earn over the life of the bond. The downside is that you will lose out in real terms if inflation turns out to be higher than the interest earned on this investment.
In the case of an inflation-linked bond, the mechanics are the same, with the important difference being that the principal does not remain constant over time. It is adjusted with the going rate of consumer inflation (with a three-month lag). Therefore, while your loan (the R1 million) to government keeps pace with the rate of inflation, so does your half-yearly coupon (or interest rate) payment. This is because the fixed, predetermined coupon rate is applied to the inflation-adjusted principal. In bond market jargon, this is what is referred to as the inflation carry.
You may ask, “What happens in the case of a negative rate of inflation?” as experienced in a number of countries over the past few years. No problem. Government agreed not to adjust the principal to an amount lower than your initial capital outlay of R1 million. Therefore, in such a case, you will actually earn more than inflation.
A word of caution though, the above-simplified version is best applied in an unrealistic and unlikely scenario where the real yields at which inflation-linked bonds trade remain unchanged over the life of the bond. An alternative scenario is when the investor holds the bond to maturity and ignores secondary market volatility between the purchase and redemption dates, i.e. a buy and hold strategy. “Why would that be?” you might ask. Well, the ability to buy and sell financial instruments like these by active investment managers is one of the cornerstones of a more sophisticated market. A frequently traded or liquid secondary market enables better price discovery, which in the end would benefit both issuer and investor. The downside to this is that the market price (or yield) may deviate significantly at times. In turn, this implies potential price and thus return volatility. The graph below illustrates this clearly