In India, the idea of investment starts with investing in Fixed Deposit (popularly known as ‘FD’). Often people, especially the working class of our previous generation, have found their peace in this investment instrument. It is so popular even today that when we introduce the term ‘Fixed income securities’ to someone, the first thought that comes to their mind is FD. And why not? It completely makes sense.
Keeping that in mind, let’s focus on FDs as an example of how fixed income securities work. Thanks to the various campaigns of the banks in India and the government, saving in FDs became a household phenomenon. FD facility available in all the banks across the country, making it very approachable to everyone, was a safe haven where you could park your extra funds and also had flexibility for you to choose the term for which you wished to park them. Additionally, they offered a really attractive rate of interest.
Source: RBI
As you can see from the chart, investors had a stable, reliable source of income from their investment in FDs. The rates had gone as high as 12% at one point. So we can all agree that given the limited knowledge coupled with limited access to funds, FDs made sense.
But like every love story we see around us, things start getting messier due to a villain. We call that party pooper ‘Inflation’.
Inflation is decline of purchase power over time. Inflation is the reason we do not lock up our funds in our lockers. It is the reason we have to stay busy and keep working for more than we earn today. It is the reason why we have to engage our saved money and invest at various places so that it does not lose its value. Consider inflation to be a character that eats from everyone’s tiffin but never gets fat.
So what can you do about it? Can you and I really tame such a seasoned beast that has plagued us with its horrors since eternity?
Consider this riddle.
Let’s say I give you a wooden stick and ask you to make it smaller. However, you cannot touch it or cut it. How’d you do?
It’s not so tough. Give yourself 30 seconds to think over. Ready?
You simply put a bigger stick beside it.
Easy ha?
That is exactly what we need to do with inflation. You as an individual cannot control or tame it. But to get on top of it and deal with it, you need to earn at a better rate than inflation.
So how does all this relate to our discussion on Fixed income securities?
Let’s say the return is 5% invested for 10 years. Also, for simplicity, let’s consider that the present rate of inflation is also 5% which will stay constant for this period.
This means that a sum of Rs. 1 Crore invested in FD at 5% and facing an inflation of 5% will have value equivalent to 1 Crore at the end of 10 years right? WRONG!
Typically, a fixed income security will give you returns at simple interest which means you will receive exactly Rs. 5 lakh every year for the next 10 years. Your total earning including principal at the end of the year will be Rs. 1.50 Crores.
However, the inflation grows at compound interest and the power of compounding can move mountains. Going by this calculation, the value of your investment after 10 years at 5% inflation will be only Rs. 92,08,700/-
| Year | Interest | Discounting @ 5% | Cumulative Interest | PV of payout |
| 1 | 5,00,000.00 | 0.9524 | 5,00,000.00 | 4,76,190.48 |
| 2 | 5,00,000.00 | 0.9070 | 10,00,000.00 | 9,07,029.48 |
| 3 | 5,00,000.00 | 0.8638 | 15,00,000.00 | 12,95,756.40 |
| 4 | 5,00,000.00 | 0.8227 | 20,00,000.00 | 16,45,404.95 |
| 5 | 5,00,000.00 | 0.7835 | 25,00,000.00 | 19,58,815.42 |
| 6 | 5,00,000.00 | 0.7462 | 30,00,000.00 | 22,38,646.19 |
| 7 | 5,00,000.00 | 0.7107 | 35,00,000.00 | 24,87,384.66 |
| 8 | 5,00,000.00 | 0.6768 | 40,00,000.00 | 27,07,357.45 |
| 9 | 5,00,000.00 | 0.6446 | 45,00,000.00 | 29,00,740.12 |
| 10 | 1,05,00,000.00 | 0.6139 | 1,50,00,000.00 | 92,08,698.80 |
Note:
- Discounting @ 5% means loss of value each year at 5% inflation rate
- PV of payout is the Present Value of payout. It tells you how much your money is worth in today’s terms
- Year 10 figure is Principal + Interest as we will also receive matured amount of principal back at the end of 10 years
This only implies that 1 Crore invested for 10 years in this fixed income security has actually led to loss in value for you. That’s why it’s usually said that fixed income securities do not provide a good cover for inflation.
I’m pretty sure you’re convinced or at least reconsidering your hard-wired thoughts about these securities giving you stable, healthy returns while providing capital protection, and also that they’re not worth it. Well sorry to say, but you’re wrong again.
There are a lot of situations that demand owning of these securities for their own benefits that they offer. We’ll keep that topic for some other time.