Picking investment products to hedge against inflation (2)

Last week in talking you through products that help hedge against inflation, I first explained three investment objectives that help steer a client’s investment decision. We talked about Safety of Funds and Fixed Income. The third one is Capital Growth, which is also key, as every investor is supposed to double the value of their principal in five years, aided by compounded interest and strategic investment plan. Let’s continue with capital growth as the third investment objective.

Capital Growth: An investment can either attract a capital gain or loss to the investor. Capital growth is only achieved when stocks or bonds are sold. It is basically a growth of capital invested in any stock or bond. Besides receiving periodic dividends on investments held, when such investment appreciates in value the holder experiences capital growth. As an example: Let us say a client bought a UBA stock at N14 and has been taking dividends for years, meanwhile over the years the company’s share value increased to N17, the holder will have to sell at N17 to actually have a capital gain or capital growth. Some investors, therefore, look to have capital growth, so their investment goal is driven by capital growth.

Every investor should have a plan and investment horizon, you can adjust the plan to suit current realities. However, it is important to have a plan and not follow whatever seems to work at the moment. At the moment, one of the biggest challenges most investors in the capital market and other investment spaces are grappling with, is inflation, and how it imparts on return on investment.

Inflation is simply the decline of purchasing power of a given currency over time. Practically, if you have a million naira and inflation rate is at 16% over one year, though your stock of money remains the same, while the prices of goods and services move up in the market, the purchasing power of your money would have reduced by One Hundred and Sixty Thousand Naira! Thus, leaving you with Eight Hundred and Forty Thousand Naira instead. It is a pain point for all investors across sectors. How do you guard against the negative impact of inflation on your stock of money or returns on your investment?

According to a report on Investopedia, “inflation can have a dampening effect on fixed-income investments, reducing their purchasing power and cutting their real rate of returns over time. This happens even if the inflation rate is relatively low. If you have a portfolio that returns 9% and the inflation rate is 3%, then your real returns are about 6%.”

Therefore, finding investment schemes that hedge against inflation, especially now that Nigeria’s inflation is still high at more than 15%, is the goal for a healthy ROI. Even when the inflation rate is low, it still has enough negative influence to water down ROIs. What happens when the inflation rate becomes higher than the average rate of returns for capital market investors? Then it becomes even more dire.

Inflation occurs in market economies; the reason investors should plan to invest in instruments that outperform the market during inflation. Some of those instruments are Gold, Commodities like grains or metals, a combination of Stock and Bond in a 60/40 ratio to strike a balance between aggressive growth and safety, while beating the market, Real Estate Investment Trusts, leveraged loans, etc. However, today, we will dwell on Treasury Inflation-Protected Securities (TIPS).

Treasury Inflation-Protected Securities (TIPS) are engineered fixed income securities, designed specially to benchmark inflation, issued by central banks on behalf of governments. It is done by regularly adjusting bond prices to catch-up with inflation. In the life of every issued bond, the bond price can swing in three ways. Either it is at par, at discount or premium. It is at par when the price is equal to issued price, at discount when it is less than the price it was issued and at premium when it is higher than issued price.

So, to benchmark inflation rate, the issuer of the Treasury Inflation-protected bond plays with the bond price specifically to hedge against the depletion of the purchasing power of investors funds by inflation. Therefore, investors’ principal rises as inflation increases, meaning also that dividend paid will also follow the principal in that increase. Since there are sizable investments in government securities, investors can look towards investment vehicles like this when they are made available.

Globally, several countries – developed, developing and underdeveloped – issue these bonds to help investors with lower risk appetite protect their investments against inflation.

Always stay investment sharp. See you next week!