Interest Rates and Inflation

Interest Rates and Inflation

The level of interest rates in an economy is not only a sign of the underlying health of the economy, it is also an important benchmark for the expected return on an investment. In particular, the returns on cash in the bank are closely tied to the cash rate, with bank interest usually slightly more than the cash rate.

You might (logically) assume that your return on cash in the bank is equal to the interest rate. While this is true in a nominal sense one needs to account for inflation to calculate the true return.

As an example, imagine you earn an investment return of 2% in a year, but inflation runs at 2% for that year, even though you have more money at the end of the year, the purchasing power of that money is not the same as it was at the beginning of the year. In effect, your investment return is 0% in real terms.

The erosion of purchasing power by inflation is sometimes called a ‘hidden’ tax and it is a tax that is levied on savers. Debtors (people that owe money) actually benefit from inflation as the real value of their debt declines. Imagine someone who owes $100,000 at the beginning of the year in an inflationary environment, excluding interest, the real value of that debt will have declined at the end of the year, thus reducing the debt burden. Inflation, therefore, is a transfer of wealth from savers to debtors.

The calculation of the real return on an investment is as simple as subtracting the inflation rate from the nominal return. With the cash rate currently at 1.5%, and annualised inflation running at around 2% based on the December quarter CPI data, real interest rates are currently around -0.5%.

This is bad news for people with cash in the bank as your purchasing power is decreasing every day (or at best, treading water). What can you do about this?

Well, in order to increase your return, you will have to also increase your risk. Investment in the stock market should substantially increase your expected return but it will also significantly increase risk.

While this is perfectly fine for some people, there are others who aren’t willing to take such a level of risk.

Another option is to invest in hybrid securities. While these certainly come with a higher degree of risk than cash in the bank, they also offer a higher expected return.

Rivkin’s Income Strategy, which holds a portfolio of hybrid securities, currently has an average distribution yield of 6.95% and has accumulated unrealised capital gains of 3% so far this year.

If this strategy sounds like something you’d be interested in (be sure to read the ‘complex securities’ warning below), please contact me at or by phoning +612 8302 3633.

Complex product warning

This article contains information about hybrid securities, which are considered complex financial products. Please click here to read the ASX's "Understanding Hybrid Securities" document before considering an investment in hybrid securities. 
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