Today, I’ll be making a case for buying inflation-linked bonds, as well as the opportunity costs associated with that. Like my last article, I will be referencing concepts from “Get to know the basics of Government Bonds” and “The low-down on Government Inflation-Linked Bonds.”
Why I will invest in Inflation-Linked Bonds
First and foremost, note that I am a university student. Being this young and fortunate enough to receive a university education at one of South Africa’s best universities has me looking forward to a bright future for myself; I have pages upon pages of career plans, both long-term and short-term. But a great deal of these plans need a large amount of money to execute. So, one of the avenues for me to take in order to protect and grow my money is through inflation-linked bonds. And while it is said that it is taking risks that keeps us young, I am prepared to forfeit my youth in exchange for some sort of guarantee about my future.
Recently, South Africa has not been having a positive economic outlook. This is especially true when one looks at the recent Medium-Term Budget Policy Statement (MTBPS) delivered by our minister of finance, and our stance with global credit rating agencies. Fitch Ratings, an accredited organization which rates the credit-worthiness of firms and governments – that is, their capacity to repay debt incurred from selling short term and long term bonds – has downgraded its view of Long-term ( > 10 years) South African Government bonds to negative at the speculative (junk status) level. What this essentially means is that the South African government has added vulnerability to fail to repay debt in its bonds that mature in more than 10 years. This will be especially true if the economic conditions and outlook of our country continue to be negative.
This rating by Fitch, which leads to a decrease in investor confidence in South Africa, could make foreign investors reduce or stop investing in South African government bonds and corporate bonds. The impact of all of this could be a shortage of money in government and a shortage of money in businesses to expand and continue to produce goods or services at normal levels. The added effect of reduced production by companies and the economy, which was itself caused by lack of investments in South African bonds, could cause high inflation. And as you remember from our last discussion, this is bad for the value of the money in your pocket.
What are you to do in this grim situation? Buy inflation-linked bonds. Why? Inflation-linked bonds are the adequate weapon to protect one’s money in such an environment.
What I am missing out
If you choose to put your money in government inflation-linked bonds you will miss out on the following:
Lending to non-institutional entities (i.e. corporate bonds)
The advantage of lending to institutional borrowers is the signing of a legal contract, whereby if any of the stipulated terms are violated, the institution can be held legally accountable and you will be compensated in some way.
This is not the case with government bonds, as there are no means to guarantee the full return on an investment into the bonds. In government bonds, there is also no way of guaranteeing some form of compensation (collateral) if the full payment due to you by the government fails to be made.
Purchase of shares
I have, in the past, bought shares in various companies and Exchange Traded Funds (ETFs) on the JSE – these can collectively be called equities. The problem with equities is the elevated level of risk, which at times may not even be compensated with handsome gains.
In the context of the article, stocks (and the corporate bonds discussed above) are particularly vulnerable to a downturn in the economy and so will not provide you with the level of security you need for your money.
Banks often offer fixed interest rates (around 6% on average) when you keep your money in their savings accounts. This is good when if you are looking for security in the uncertain economic conditions that we find ourselves in today.
However, should it be the case that the inflation rate exceeds the interest rates offered by banks, your money will begin to lose value despite being in a savings account.
Fixed Rate Government Bonds
As stated in my first article in this 3-part series on government bonds, there are inflation-linked bonds as well as non-inflation-linked bonds. Although non-inflation-linked bonds do not offer the advantage of counteracting the effects of inflation on your money from time to time, the interests rate of these bonds (starting at 7.25% for the two-year bonds) could be enough to guarantee that inflation does not decrease the value of your money too much.
These bonds often have negligible risk, no transaction costs, and have administrative procedures like the ones of inflation-linked bonds. That’s why I think that these bonds as the best alternative to inflation-linked bonds, especially for a person who is more optimistic about the state of the economy of South Africa in the short-term (less than a year).
My final thoughts
The articles that I’ve written in this series, and the opinions and conclusions I reached, are specific to my situation. In writing them, I am hoping to equip you, the reader, with a framework on which you can base your long- and short-term financial decisions on.
I hope I’ve given you an example of how to investigation ways of growing your money and be knowledgeable about the latest changes in economic policy and in the current and projected well-being of various industries. My wish is to see you keeping up to date with the latest statistics and other forms of information about the well-being of the economy. All of these are the factors that influence the state of the economy, and they will dictate how to invest your money wisely.
This article was written by Liso Mdutyana.
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