Saving vs Investing

IT is without doubt that inflation poses a threat to investors as it has the ability to chip away savings and investment returns.

The presence of inflation makes it harder for investors to increase their long-term purchasing power, as investment returns must first keep up with the rate of inflation in order to increase one’s real purchasing power.

While investors are aware of the impact of inflation on their investment portfolio, they still tend to flock to regularly accepted asset classes such as equities, commodities like gold and oil, or real estate.

However, fixed income instruments are largely ignored by investors even though there are certain strategies that can be used to hedge against inflation from eating into fixed income returns, except in periods of hyper inflation.

Given their low volatility and consistent stream of returns, fixed income assets provide an alternative form of defensive measure to an investor’s portfolio and provide a real rate of return.


Adopting a suitable fixed income strategy
There are many fixed income strategies that investors can adopt, one of which is to place all fixed income investments into a money-market fund and reinvest all income payments into the fund as well.

Ideally, the interest rate earned on a money-market fund should at least compensate the current rate of inflation.

As the yield on the funds adjusts to current short-term interest rates, it should theoretically keep pace with a rising inflation scenario.

This is a better avenue compared to investors placing their money in fixed deposits as the rates in Malaysia historically do not adjust to inflation rates effectively, and thus investors would be earning negative real returns most of the time.

Investors could also look at another fixed income strategy — investing in long-tenure bonds. The volatility of the market has resulted in investors being risk-averse, which sees them unwilling to take high credit, liquidity and duration risks.

Also, Malaysia’s inflation in 2009 and 2010 is expected to remain tame at 3.5% and 2% respectively. This presents an opportunity for investors, especially those with holding power, to invest in longer tenure bonds with good credit quality at attractive yields.

This strategy aims to increase the income available by moving investor’s investments into bonds with longer maturity.

Ideally, this should be undertaken when the yield curve is steep — where long-tenure bond yield is higher than short-tenure bond yield — or if we believe that long-tenure bond yields have already peaked.

Even though money-market fund yields adjust regularly because they are shorter-term, the higher yield in long-dated bonds should make up for this.

For retirees who no longer have the ability to add to their fixed income portfolio and would need income at hand for living expenses, a useful fixed income strategy to adopt would be the Bond Laddering approach.

Bond laddering simply refers to the diversification of a bond portfolio through purchasing a series of bonds that have increasingly longer terms to maturity.

Let us consider a simple ladder — assuming an investor wants to keep his average bond term to three years and therefore purchases one-, two-, three-, four- and five-year bonds in equal proportion. This ladder would then have a weighted average maturity of three years.

We have constructed a sample using actual bonds and actual market yields, and assumed that the investor started his ladder portfolio in 2007.

Results show that the ladder has consistently performed better than inflation during each investment year.

By allowing investors to keep the average weighted maturity of their bond portfolio down, this strategy is especially helpful in managing interest rate risks associated with longer term maturities.

Ladders allow investors to take advantage of environments where interest rates are trending higher. The liquidity created within the bond portfolio when a security matures allows for the reinvestment at higher interest rates and if interest rates are not higher, investors will continue to have a majority of their portfolio in higher yields than the market. This in effect helps minimise the risk of inflation eating away the purchasing power of their investments.

Out of the three fixed income strategies, the ladder strategy is the most favoured.

Despite its lower real returns (albeit better than investments in money market) as opposed to long-term direct bond investments, the ladder strategy provides flexibility and liquidity.

The ladder approach is recommended to fixed income investors and high net-worth clients as part of their defence against inflationary and interest rate risks.