Fixed-income investments are considered to be stable and steady. However, there are factors impacting the yield of these instruments. One such factor is inflation. Inflation refers to the rise in the level of prices of commodities, services etc., They tend to have an impact on the fixed income instruments as well. As an investor, it is important to understand this phenomenon in a detailed manner to effectively mitigate the situation and continue to generate optimal returns on your portfolio.
What is inflation?
Inflation is a key cyclical macroeconomic indicator which influences the activities in the economy. This phenomenon affects the smallest unit within the economic ecosystem. From an individual’s perspective, household expenses increase when inflation increases. This phenomenon also impacts central banks, policymakers, manufacturers and consumers alike.
Hence, it does not come as a surprise that given their far-reaching repercussions, investment avenues are also impacted significantly. Capital markets tend to see a downtrend during inflationary times. Inflation impacts the returns yielded from investments made by an individual. Thus, the concept of inflation-adjusted or real returns gains significance while an investor assesses any investment. Real returns are the nominal returns adjusted for average inflation. Like all other asset classes, inflation affects fixed income as well.
How does inflation affect fixed-income investments?
Fixed-income investments are the most impacted due to inflation due to their inherent inverse relationship with interest rates. The basic ideology of investment is to beat the inflation rate. As inflation rises, individuals are on the lookout for investments which will provide them with returns higher than that of the inflation rate.
However, for any fixed-income investment, the interest rates do not change. This becomes counter-intuitive as they become less attractive to investors. Thus their prices tend to fall as investors are keen to sell off their low-yielding fixed-income products to look for better investments during these inflationary times. Hence, fixed-rate debt instruments are the ones that stand to lose the most in a rising inflationary environment.
To control inflation, there are times when regulatory bodies step in, primarily to protect the interests of the end consumers and retail investors. The central banks can take relevant actions around the monetary policy and liquidity in the system to manage the interest rates and yields on debt products. However, the fundamentals almost always catch up and hence, it is primarily important to strengthen the economic ecosystem by creating jobs, having a stable socio-political stance and a strong currency.
Investment options during inflationary times:
There are many advancements within the financial ecosystem. There are instruments which counter such inflationary times. Inflation-protected securities are a bond category that adjusts the yields generated from the instruments in accordance with inflationary trends. This could help counter rising inflation. The interest rates on these products are revised to ensure that they continue to yield higher than inflation. Another perfect debt instrument which works well during inflationary times is the floating rate funds. As their name suggests, they do not have fixed interests attached to them. The interest rates on these funds are revised based on the increase or decrease of interest rates which are in turn driven primarily by inflation.
Inflation is always going to be a critical phenomenon. In a continuously evolving economy like India, they are likely to play a more prominent role. Further, they will always be the silent thief who will continue to eat into your long-term yields. The only way to work around these factors is to identify instruments which act as a hedge against inflation. There are a few instruments, such as inflation-protected securities and floating rate funds, within the debt universe. Also, other asset classes, such as gold, considered a haven during inflationary times, can be considered. A well-diversified portfolio enables the investor to weather any storm in the economic ecosystem.
Fixed-income securities are integral to your portfolio as they tend to preserve capital and offer stability to the portfolio. However, there is a need to design this part of your portfolio such that it continues to optimise returns even during inflationary times. Designing and managing your portfolio can be an arduous task at times. You can always reach out to experts at TATA Capital to help you design a portfolio that aligns with your requirement and risk profile.