How does inflation affect fixed income: Let us Talk

 How does inflation affect fixed income: Let us Talk.

                                                                                    Image by pixabay.com/users/mohamed_hassan-5229782/                                   

Many people are depositing their money in fixed deposit of the bank because of the no risk, hassle free procedure and expecting for good returns. Is it really happen?

We have to consider it by two ways either for safety, security or as an investment.

The young generation should think from investment point of view and elders think it from security, and risk free investments with expected returns. For elder people from risk free investment is okay but from expected return it is a dicey question.

But present fixed deposit risk is up to only 5 lakhs as per Deposit Insurance and Credit Guarantee Corporation (DICGC) guideline (from current year-2020)

Let us examine from expected returns or investment point of view.

India’s latest inflation rate is on rising trend, it touches to 6.09% in the month of June 2020. The savings and fixed deposits are as of now varying between 3.0 to 6.7s max as below.

HDFC	3.00% – 6.25%	7 days to 10 years
ICICI Bank	3.25% – 6.25%	7 days to 10 years
Axis Bank	3.50% – 6.75%	7 days to 10 years
SBI	3.30% – 6.50%	7 days to 10 years

The difference between the inflation rate and fixed deposit interest rate is very narrow that means people are actually losing their money than earning the in fixed deposit.

What is inflation?

Suppose you have got Rs. 1000 in your savings bank account and let’s say that the bank is giving an rate of 1 per cent. This effectively implies that within a year, your account would have Rs 1010. Although initially sight, it looks as if you earned Re 10, it’s not really the case. If within the same year, the speed of inflation was, say 5 per cent, it means you'd require Rs 1050 to possess the same buying power that you simply began with. So although you’ve gained a ten rupee, you’ve lost your buying power. This effectively implies that if your savings are growing at a rate slower than the rate of inflation, you’re losing money. and therefore the wider that gap is, the heavier is your loss.

Let understand by actual calculations.

Formula

 Where

V = Present Value, n = Holding Time, I = Interest Earned Each Year,

P= Principal, r =inflation factor.

Let’s find out the value on a fixed deposit using the above formula. The details of the fixed deposit is mentioned below:

•          Deposit Value (P): Rs.100, 000.

•          Interest Rate Offered: 6.00% p.a.

•          Period (n): 5 Years.

•          Inflation Rate (r): 6.09% p.a.

Here we will consider two case like 1) Interest payable yearly and 2) Interest + maturity payable after the completion of tenure:

•          CASE-1: INTEREST PAYABLE AT THE END OF EACH YEAR

As stated above the inflation rate r=6.09% then by investing money into fixed deposit for 5 years what will be returns from the fixed deposit.

The above data shows that in year zero, the cash flow is negative (-ve) Rs.1.0 Lakhs. Because the money is being invested into the FD. In the succeeding five years, the interest @6% p.a. flows in. In addition to this the principal amount also flows back-in at the end of the fifth year.

To calculate the Present Value of these cash flows, the mathematical formula will look like this.

 Present estimation of all incomes occurring between year zero and the future five years is Rs.- 37 (negative) As the worth is negative, it implies that the venture does not merit spending-in. Why this is occurring?

Due to the negative impact of inflation (@6.09% p.a.). Had the inflation rate be lower than the "interest rate” offered by FD's, available worth would have been positive.

At the end of the day, our Rs.100, 000 will be more fragile by Rs.37 following five years. If you don't mind note that this same impact as above is going on even after it remained contributed for all the five years

CASE 2 – INTEREST + PRINCIPLE AMOUNT PAYABLE AT MATURITY

Here same assumptions will be applied i.e. inflation rate is considered as 6.09% Deposit amount is 100000/- and rate of interest is 6% and tenure of deposit is 5 years.

Let us see practically by calculation:

Here: 33,822 = [1, 00,000*(1+6%) ^5 – 1, 00,000]

The above data shows that in year zero, the cash flow is negative (-ve) Rs.1.0 Lakhs. This is the year where the money is being invested to buy the FD. The next cash flow happens only after the end of fifth year. This will be interest plus the principal (Rs.1, 33,822).

To calculate the ‘present or current value’ of these cash flows,

 

“How much “net extra cash” this fixed deposit is going to bring-in into our pockets after five years – considering the impact of inflation? The net extra cash flow will be again in negative (-423). In other words, our Rs.100, 000 will be weaker by Rs.423 after five years

Here we have not considered the tax deduction case. The TDS rate on fixed deposits (FDs) is 10% if the interest amount for the entire financial year exceeds Rs 40,000 for AY 2020-21. For the above example there will not be any TDS applicable however for higher amount it will be applicable and hence effective returns on fixed deposit will again get decreased. It will also depends on the taxable slab also.

So, in order to keep purchasing power as earlier Rs 1 lakh should grow at an after tax rate of 7% the Rs 1 lakh will be converted to Rs.1,40,255/- in 5 years so that at least he would get some positive returns than the inflation provided the inflation rate remains steady as stated above ( 6.09%).

For the individual who is in 10% income tax bracket should get returns at 8%, for 20% and 30% tax bracket individual should earn @ interest rate of 8.75 and 10.14% to overcome the inflation.

Conclusion: Hence, fixed deposits are not wealth investment for long period. This is applicable for the younger generation it is a great saving option.

But for elder people i.e. Senior Citizen it will be useful from the safety, security risk point of view off course they should not rely totally FD interest. There are other options available who gives higher returns than the FD like senior citizen scheme, corporate deposits, NBFC, Housing Finance, Debt mutual fund etc. But before investing they should check the reliability like ratings, background etc.