WORDS ON WEALTH
When recently answering a reader's query about RSA Retail Bonds, I was again struck by what good value these products offer currently, particularly for retirees requiring risk-free, steady retirement income.
These bonds, offered by National Treasury and available to South African consumers, come in two types: those that have a fixed rate for the term of the bond, and inflation-linked bonds, which have a lower rate but in which the capital is adjusted by the inflation rate. While the fixed-rate bonds can be used for saving or for income, as interest compounds over the term if reinvested, the inflation-linked bonds can only practically be used for income, because interest is paid out and therefore does not compound.
The current rates beat virtually anything available from comparable bank or money-market investments. Working on the January Consumer Price Index inflation rate of 5.5%:
- On a fixed-rate bond over five years (the maximum term), you get an annual return of 9.25%, which is 3.75% above January CPI.
- On an inflation-linked bond over 10 years (the maximum term), you get an annual return of 4.5% in addition to your capital (and hence income) being adjusted twice a year for inflation.
On top of the rates being very attractive, there are zero fees.
As on any investment, you pay income tax on interest, subject to exclusions, exemptions and deductions applicable to you.
If you are investing a lump-sum for an income, you need to weigh up which – the fixed-rate or the inflation-linked bond – will serve you better, and this will depend on several factors:
- For how long you intend to remain invested;
- Whether you want to preserve the real (after-inflation) value of your capital – so that it has the same buying power at the end of the term as when you invested it – or are willing to let your capital depreciate by inflation over the term in exchange for receiving a higher income initially; and
- Your view of inflation: do you expect it to remain contained within the government's 3-6% range, or to increase beyond 6%?
I compared a R1 million investment in the two products over 10 years under two inflation scenarios. To simplify the comparison I kept the rate for the fixed-rate bond constant for the 10-year period, although you would need to re-invest after five years at what could be a different rate. My reasoning was that if inflation was the same after five years, the rate would probably remain the same, and if inflation was higher, the rate would be higher, which would benefit you even more than I have calculated. Also, I have adjusted capital for inflation only once a year, at the end of each year.
In this scenario inflation remains a constant 5.5% over the 10 years. (If fluctuations were minor, both up and down, then you could work on 5.5% being an average.)
a) Inflation-linked bond: At an interest rate of 4.5%, you would receive an income of R45 000 in the first year. This would increase by the inflation rate each year, as would your capital, so that in year 10 you would receive R72 859 and your capital at the end of year 10 would be R1 708 144.
b) Fixed-interest bond: At an interest rate of 9.25% you would receive an income of R92 500 each year for 10 years. With inflation reducing the buying power of that amount, in the 10th year, your income would be worth R55 594 at today's rand value. However, the R92 500 you receive would still be higher than the R72 859 (R45 000 at today's rand value) you would receive in year 10 of the inflation-linked bond. But your capital would have depreciated by about 43% to R567 960 at today's rand value.
In this scenario, inflation rises by 0.5% a year so that in the 10th year it is 10%.
a) Inflation-linked bond: Again, you start with an income of R45 000 in the first year, rising by inflation so that you would receive R86 220 in the 10th year. Your capital would have increased to R2 107 594 by the end of the 10th year.
b) Fixed-interest bond: The R92 500 you receive each year would be ravaged by inflation, but in year 10 it will still be more than the R86 220 you receive from an inflation-linked bond. However, your capital would be severely depleted, having lost 55% of its value – it would be worth R445 797 at today's rand value.
In both inflation scenarios, over 10 years, your cumulative real (after-inflation) income from a fixed-rate bond at 9.25% will be higher than that from an inflation-linked bond at 4.5%. The cost will be the depleted value of your capital. Over longer periods, however, the inflation-linked bond slowly gains the upper hand regarding cumulative real income, while your capital retains its original buying power.
Disclaimer: this article is for information purposes and should not be construed as financial advice in the legal definition of the term. Before making any investment decisions you should consult a qualified financial adviser.