How inflation affects your fixed-income investments and what you can do about it

Inflation significantly affects returns on fixed-term investments by influencing interest rates, particularly through changes in the Repo Rate.

The current inflation landscape is intricate, holding significant sway over economic dynamics and investment strategies. Within the realm of investments, fixed-income options, encompassing bonds and debt instruments, stand out for their appeal. These financial instruments offer regular interest payments to investors, making them an attractive choice for individuals seeking stable and predictable returns.

Inflation exerts a multifaceted impact on fixed-term investments, primarily manifesting in the erosion of purchasing power. As the general price level escalates, the purchasing ability of the fixed returns from these investments diminishes, leading to a decreased real value.

In its latest December policy meeting, the RBI's Monetary Policy Committee (MPC) opted for continuity by maintaining the status quo, keeping the Repo Rate steady at 6.50 percent This decision aligned with market forecasts and the MPC members were unanimous in taking it. Notably, this marks the fifth consecutive policy meeting in which the Repo Rate has remained unchanged.

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Influence on investment returns

Inflation significantly affects returns on fixed-term investments by influencing interest rates, particularly through changes in the Repo Rate.

The Repo Rate, which is the rate at which central banks lend to commercial banks, plays a role in this. When the Repo Rate increases, fixed deposit (FD) interest rates also rise, and when it decreases, FD interest rates fall. Furthermore, central banks raising interest rates to combat inflation can cause bonds with lower yields to lose value, potentially causing financial losses for investors who must sell their bonds prematurely.

Investors often employ strategies like diversification and inflation-protected securities to protect their fixed-term investments from the impact. Yet, when inflation consistently outpaces fixed-income yields, investors face challenges, especially with rising food and fuel prices, resulting in negative real returns.

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A lower Repo Rate reduces the cost of capital for banks, leading them to rely less on fixed deposits to meet capital needs and subsequently lower FD interest rates. Conversely, when the Repo Rate rises, banks increase loan interest rates and, in turn, offer higher FD interest rates to attract depositors.

Thus in the current scenario, a stable Repo Rate at around 6.50 percent is ideal for FD interest rates.

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Mitigating inflation related risks in fixed-income investments

Diversifying a fixed-income portfolio by including bonds with varying maturities and yields can mitigate the risk of inflation. Longer-term bonds often offer higher yields, potentially keeping pace with inflation and preserving purchasing power.

Floating rate bonds, which adjust interest rates periodically in line with reference rates, can shield against rising interest rates and inflation. They offer investors an opportunity to benefit from increasing rates.

Investing in real assets such as real estate or commodities can act as a hedge against inflation in the Indian context. These assets tend to appreciate during inflationary periods, potentially offsetting losses from fixed-income investments.

The current inflation scenario in India poses a significant challenge for investors seeking stability and consistent returns from their fixed-income investments. To safeguard their portfolios against the adverse effects of market volatility, investors must prioritise diversification.

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In any evolving economy, inflation is an unavoidable phenomenon that exerts pressure on long-term yields, potentially eroding the value of fixed-income investments over time. Therefore, it is crucial for investors to thoroughly assess their long-term financial objectives, liabilities, and risk tolerance before making investment decisions. The RBI’s efforts to manage and control inflation will play a pivotal role in shaping the future of fixed-income investments in the country.