March 16, 2010
By Margarete King
Now that the economy has gone pear-shaped, economists say the outlook for a recovery could be U-shaped (even V-shaped for the particularly excitable), W-shaped or L-shaped.
By the U and V shapes, economists mean there could be a quick turnaround from recession. The shape of the letters mirrors an imaginary graph of important economic indicators, such as gross domestic product, in which the indicator falls precipitously and then recovers equally quickly. But there could instead be a double-dip recession (the W-shaped scenario) or a prolonged recession (the L-shape).
Throw into this mix debates about whether the nations of the world will also experience "normal" levels of inflation, or considerably accelerated inflation because of the stimulus packages that have been put into place, or even deflation, and discerning the shape of things to come is more confusing than ever.
You, as a consumer, are told from all sides to pay down your debt and then save. But the inflation rate is running ahead of any interest rate you can get from a bank, and, while the debt-burdened celebrate every interest rate cut, those who are living on interest income from fixed-interest investments know that their budget just got a notch tighter.
One way you can keep your capital intact while simultaneously staying ahead of the effects of inflation is by investing in one of the National Treasury’s inflation-linked RSA Retail Savings Bonds.
In 2004, then Minister of Finance Trevor Manuel launched the RSA Retail Bonds with the aim of providing you, the smaller investor, with access to cheap and safe medium-term investment options. You can choose between terms of two, three or five years, and interest rates are fixed for the entire term with the interest either paid out or reinvested.
But Gregg Sneddon, an independent financial planner who runs a fee-based practice in Cape Town called The Financial Coach, says one of the problems with fixed-interest investments is they often don’t keep pace with (or beat) inflation over the longer term. To counter this, he says, the National Treasury launched inflation-linked retail bonds in 2007.
With these bonds, your capital is adjusted for inflation every six months, and on top of that you earn interest. In August, the interest rates were 2.25 percent a year for the three-year bond; 2.5 percent (five-year bond) and 2.75 percent (10-year bond).
The interest rates fluctuate, so whatever the rate offered you when you invest is guaranteed only until the next interest payment date. Interest is paid on May 31 and November 30 each year.
The interest rates are an average of the yields of the previous six months of government inflation-linked bonds as they are traded on the Bond Exchange of South Africa (now part of the JSE), Johan Krynauw, the director in the asset and liability management division of the National Treasury, says.
Krynauw says the rates usually remain in a bracket of between 2.25 percent and 3.25 percent, depending on market conditions.
But some questions:
What would happen if, somewhere along the line, deflation takes hold? I don’t mean disinflation, which is a slowing of the rate at which prices rise. I mean a widespread, sustained drop in prices, which economists call negative inflation. Would the treasury reduce your capital?
"We would never do that," Krynauw says. "If there is negative inflation, we will never pay less than the original nominal amount deposited. If you deposited R1 million, you will get at least R1 million."
Sneddon points out: "So even if there was negative inflation, you would still stay ahead of the curve, because you would not lose any capital."
What measure of inflation is used? Krynauw says the treasury uses the rate reflected by the headline consumer price index (CPI) for all urban areas.
In July the rate was 6.7 percent. This means the price of the basket of goods that Statistics South Africa monitors was 6.7 percent higher than it was in July 2008. In June, the year-on-year inflation rate was 6.9 percent, so the pace at which prices were increasing year on year slowed between July and June. In February, prices were racing ahead at 8.6 percent.
"Your capital is adjusted with inflation, but inflation doesn’t proceed at a steady pace," Krynauw says.
The inflation rate is like a car speeding along a highway – at times it may get up to 130 km/h and at other times it may slow down to 80 km/h. And the inflation adjustment is like a photograph from a speed camera – it reflects the speed at which the car was travelling at the moment the picture was taken, not what it was doing 10 minutes before the car crossed the speed trap. In the same way, the inflation rate may accelerate to, say, 13 percent and slow down to six percent, but what matters to your investment are the rates relevant at the time when the inflation adjustment is calculated.
Once that adjustment has been done, the interest is calculated. The interest rates quoted above are yearly rates, so the rate is divided in half to work out the rate you will be paid twice a year. Your interest earnings are paid out and you do not have an option to capitalise them. You could, however, buy another bond with your interest payment if it was more than R1 000. (The minimum you can invest is R1 000 and the maximum has just been raised to R5 million.)
There are drawbacks
The rise in your cost of living is unlikely to mirror exactly the official index, which is an average for all urban areas. For example, although the overall rate in July was 6.7 percent, prices for Gautengers rose 6.4 percent, whereas they rose at a more urgent 7.8 percent for people living in Mpumalanga. Not only that, the rate for pensioners in urban areas was 7.3 percent. Rural dwellers typically experience faster price rises – in July of 7.1 percent.
Another thing to consider is that you cannot use your investment as collateral for a loan.
Sneddon says you need to be aware that once you invest more than about R220 000 (if you are under 65 and have no other interest-earning investments) and approximately R320 000 if you are a pensioner in the same position, there will be some income tax to pay on the interest income earned, so the real return will be reduced. "So it’s not as attractive as it may first look, but it is still better than inflation," he says.
The figures relate to an annual return of about 9.25 percent, which is roughly the return you would have got in July. In 2009/10, the amount of interest you can earn before paying tax on it is R21 000 if you are under 65 and R30 000 if you are aged 65 or over.
"Investors also need to be sure they don’t need quick access to the funds, because you are locked in for at least 12 months and will pay early-exit penalties after that," Sneddon says. He recommends you keep funds for emergencies in a money market unit trust and not in an RSA Retail Bond.
The website (www.rsaretailbonds.gov.za) explains the calculations for penalties. According to the terms and conditions on the website, you may be allowed a withdrawal during the first year under "extraordinary circumstances" but you have to apply for permission.
Apart from the early-exit penalties, there are no costs involved in taking out or cashing in a bond.
Your retail bond also provides a way of getting an income stream to your dependants soon after you die. Once the necessary documents have been submitted to the National Treasury after your death, your nominated beneficiaries will receive payment within 20 days. The payment will still form part of your estate for the purposes of calculating estate duty.
Sneddon says: "I think that this inflation-linked bond is a great offering to investors. While the interest on the fixed-rate bonds may appear more attractive in the short term, there is a very real danger that you could end up under-performing inflation, especially if inflation rises quickly."
He points out that the interest rate on the two-year fixed-interest bond is 9.25 percent and, with CPI at 6.7 percent, investors would have been 2.55 percentage points ahead of inflation in July. "If inflation falls further, you will be even better off in the short term, but if inflation surprises on the upside while you are still invested and increases to about eight percent, you will only be about 1.25 percent ahead.
"With the inflation-linked option, you will always be ahead of inflation – and that is key for an investor! So I guess if you are of the view that inflation will fall further, you should opt for the fixed-rate bond; if you feel inflation is too unpredictable and could surprise on the upside, go for the inflation-linked bond.
"For investors who are concerned about excessive market volatility but who still need to beat inflation, the inflation-linked bonds are an excellent alternative. So for someone who does not have a tax problem and who is wary of the equity market, inflation-linked bonds could provide a safe and stable way of staying ahead of the investor’s biggest enemy."
You don’t need to provide proof of your address when buying any RSA Retail Bond. Your address does not have to be verified for the purposes of the Financial Intelligence Centre Act (Fica), because the treasury is not an institution covered by Fica.
This article was first published in Personal Finance magazine, 4th Quarter 2009.See what’s in our latest issue
  
 
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