Tough times for the conservative investor

Suresh Krishnamurthy

THE investor who relies fixed-income investments is in for a challenging time.

The yield on investments is declining, taxes are set to rise, and inflation is getting problematic. The cumulative effect of the three factors is the need for greater savings to achieve investment objectives.

With incomes relatively inelastic or, at best, growing modestly, a larger quantum of savings to compensate for lower returns requires deep cuts in expenditure. But that is easier said than done. This is where the challenge lies for the investor — balancing the needs for consumption now to achieve future targets.

Real rates

The major problem is that the yields on investments across various maturities in nominal terms have declined 2.5 per cent since April 2001. This would not have posed any problem had the rate of increase in consumer prices too slowed down. That, however, did not happen. The annual rate of inflation was 4.8 per cent for urban non-manual workers at end-October. In April, it was 4.7 per cent.

For the real rate of return to remain stagnant, the rate of inflation has to decline to around 2.1 per cent. As this seems unlikely, even over the medium term, the net result is that the real rates of return for the investor are set to decline.

Simply put, the real rate of return is the difference between nominal return and rate of inflation. In working towards an investment objective — say, buying a house — the price target is not static but moving up because of inflation. As such, only the excess return over inflation will help an investor accumulate the wealth needed to fulfil his objective.

The real rate of return for a one-year government security bought in April 1998 declined to 0.76 per cent from 2.76 per cent for a security purchased in April 1996. Subsequently, however, it rose to around 4.7 per cent for a one-year government security purchased in April 2000. Overall, the geometric mean of the real rate of return in the past five years for a one-year government security purchased in April has been 2.43 per cent.

Now, if the rate of inflation stays at the present 4.8 per cent, the real rate of return could decline to around 2.0 per cent. This is, assuming that the official indicators of inflation are reliable. That, unfortunately, appears to be an incorrect assumption. The National Statistical Commission itself says that the data on WPI and CPI are not satisfactory. Therefore, if official inflation understates inflation, the returns could be even lower.The same trend of falling real rates is likely in the case of longer-dated maturities too. This is because yields on longer- dated securities have also declined as sharply as the yields on one-year government security.

The challenge is compounded because of three other factors — the objectives for which wealth is accumulated may rise at a rate higher than the CPI; investors have to consider the characteristics of the city in which they live; and, lastly, taxes.

Objectives and deviations

It is reasonable to believe that inflation in goods and services, such as housing and education, for which investors accumulate wealth can be expected to rise at a rate higher than that indicated by CPI. As India's birth rate is higher than the death rate, the demands on the education system are only likely to rise.

Rising demand usually leads to rising prices. Similarly, the demand for housing can only rise, leading to higher prices. The higher rate of inflation will, then, need higher savings to achieve these objectives in the backdrop of lower nominal returns.

Another factor is the differences in price levels among various cities. The consumer price index number for Chennai stands at 458 at the end of October 2001, whereas it was only 358 in Kolkata.

Importantly, the rate of inflation for the period ended October 2001 was 7.5 per cent for Chennai and 1.7 per cent for Kolkata. The higher index numbers also indicate that inflation in Chennai has traditionally been higher.

In such a backdrop, investors in Chennai have to save more than their compatriots in Kolkata to combat inflation if the trend is assumed to continue. The third factor is taxes. There has been enough indication that the number of tax incentives for savings provided under the tax laws in the area of personal income taxes will be whittled down. Incentives under Sections 80-L, 88 and 80 CCC are particularly under the microscope.

Removal of such incentives will enhance the incidence of tax on incomes.

In addition, economic theory suggests that burgeoning fiscal deficit only implies postponement of taxes. In the context of the lower economic growth, this appears particularly likely.

Greater savings

Cumulatively, the forces at work require the investor to save more in order to be in a financially comfortable position.

For example, if an investor requires Rs 1,00,000 in present value terms at the end of five years he would have had to save Rs 1,365 per month if the real rate of return was 4 per cent.

At 3 per cent, they will have to save 5 per cent more each month. At 2 per cent, they will have to save 10.5 per cent more each month.

For consuming the present value of Rs 5,000 every month for the next 15 years with real rate of return of 4 per cent you would need to have Rs 6,75,000 in the bank.

If the return is 3 per cent, you would need Rs 50,000 more in the bank and if the return is 2 per cent, you would need Rs 1,00,000 more in the bank.

Overall, the writing on the wall for investors is clear — cut back on expenditure to ensure that you achieve financial targets.

Those unable to cut back expenditure or faced with rising expenses may be forced to seek the high-return, high-risk area of equities to balance present and future needs. Either way, greater financial discipline now appears to be the need of the hour. Or else, pray for rising yields on investments and lower inflation.