TL;DR

  • Inflation is one of the main destructors of our wealth and as a result our purchasing power.
  • In Indonesia, inflation today is hovering at ~6%, and as a result, an investment portfolio would need to generate returns above 6% to beat inflation. But typically with higher inflation, comes higher interest rates. There’s an opportunity to earn higher returns in fixed income or deposits. We call this inflation-protected returns and we think this is a good starting point when retail investors think about investing objectives.
  • Putting our money in Bank Deposits that yields 3.65% is unattractive, especially considering that to protect inflation our portfolio would have to yield higher than ~6%. In our portfolios, we aim to get at least 5% return per year from bank deposits. This is done by choosing banks that provide higher deposit rates and negotiating with banks on higher rates depending on our amount.
  • We can generate a yield above 6% to beat inflation by holding longer-tenor bonds but with few considerations, including Cost Yield and interest rate expectations. The question becomes what is your holding power and when do you need your investment back.
  • We think investing in Fixed Income requires a detailed process - beyond simply picking deposits or bonds with the highest yield to beat inflation. We need to consider our time horizon for investing and how inflation and interest rates will move within this period. If our investment horizon is short, then we would opt for shorter term bonds and deposits. Vice versa, If our investment horizon is longer, then we would hold longer tenor bonds. 
Image by Towfiqu Barbhuiya

We previously wrote about building portfolios using funds across asset classes, and explained the benefits of investing through Reksa Dana. With this context, we would like to dig deeper and share our philosophy on investing in these asset classes - but specifically for this article, in fixed income.

Investing for an Objective: Inflation Destroys Wealth

One of the many reasons we typically invest is to protect our wealth against inflation. Inflation is a hotly discussed topic these days, but that wasn’t always the case. Before the pandemic, inflation and interest rates were historically low in developed markets, so investors were finding returns in the stock market. Meanwhile in Indonesia, inflation has historically trended higher, similar to many other developing countries. Simplistically, this is because economic growth is higher, driving inflation higher, and as a result interest rates tend to be higher as well. What many investors don’t realise is that inflation is one of the main destructors of our wealth and as a result our purchasing power. Inflation persists across time and it is often hidden as time passes and so it is up to us to manage and protect our wealth inflation. 

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Let’s take an example with something relevant and for many, a guilty pleasure: KFC. In 1994, a combo meal cost Rp. 4,500. Today in 2022, a similar combo meal cost Rp. 55,000! That is a 12x increase (or roughly 9.35% per year) in 28 years!

Inflation today remains high due to global macroeconomic conditions, and we think this phase could last for a while. Setting this as context, I would like to explain our investment philosophy of allocating to fixed income and money market instruments, so that our portfolio is protected from inflation. 

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Returns vs. Liquidity 

To protect your wealth against inflation, then simply we would require your wealth to achieve  a higher rate of return vs. inflation. We call this inflation-protected returns and we think this is a good starting point when retail investors think about investing objectives. In Indonesia, inflation today is hovering at ~6%, and as a result, an investment portfolio would need to generate returns above 6% to beat inflation. But typically with higher inflation, comes higher interest rates (as a means for Central Banks to control and slow down inflation). As a borrower, this hurts interest payments. But as a saver, there’s an opportunity to earn higher returns in fixed income or deposits. 

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The benchmark interest rate in Indonesia is set at 5.75%; while the Average 1 Month Deposit Rate for Indonesian banks is 3.65%.

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The BI 7-Day (Reverse) Repo Rate is the benchmark interest rate set by Bank Indonesia. Bank Indonesia uses the benchmark rate as a lever to influence the interest rate your bank would offer borrowing and deposits, and consequently, business activity in an economy.

The Average 1 Month Deposit Rate (sourced from Bloomberg) is the average deposit rate for 1 month tenor for all banks in Indonesia. 

Note all rates are gross of tax.

Putting our money in Bank Deposits that yields 3.65% is unattractive, especially considering that to protect inflation our portfolio would have to yield higher than ~6%. A reasonable explanation to this is that Banks in Indonesia today, on average, hold a lot of liquidity and do not need to charge high deposit rates to attract investor’s money. This is where we have to be picky on the type of bank deposits we invest in. Depending on the bank’s balance sheet, size, and profitability, we can get deposits that yield in the range of 3.5% and 6%. In our portfolios, we aim to get at least 5% return per year from bank deposits. This is done by choosing banks that provide higher deposit rates and negotiating with banks on higher rates depending on our amount.

Fund managers who manage Reksa Dana Pasar Uang (Money Market Funds) are able to negotiate better rates than that of retail investors due to the size of deposits they place in banks.

If we can’t achieve returns higher than the inflation rate, then where do we go? Beyond deposits, we would explore Indonesian Government Bonds. Government bonds can earn higher returns but may experience higher price volatility since these are publicly traded. Unlike deposits, the yield (coupon divided by the price of a bond) on a bond fluctuates depending on price. 

In the table above, we’ve put together the yield on a variety of bonds across different tenors. The good news is we can generate a yield above 6% to beat inflation by holding longer-tenor bonds. But, there’s a catch! First, while we invest in a bond, the yield at the time we buy (often called Cost Yield) only applies when we hold till the bond matures. That is when the issuer (in this case the government) pays us back our full amount at a later date (often called Maturity Date). Second, the yield now may move depending on the market’s expectations of where interest rates move. If interest rates are higher, bond prices fall and we may experience some losses. On the other hand, if interest rates are lower, then bond prices rise, and we may experience some capital gains. Therefore the question is, what is your holding power and when do you need your investment back.

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Liquidity 

That brings us to liquidity, which considers your time horizon for investing, and how inflation and interest rates will move within this period to ensure we can generate higher returns than inflation. If our investment horizon is short, then we would opt for shorter term bonds and deposits. Vice versa, If our investment horizon is longer, then we would hold longer tenor bonds. 

We continually stress test our portfolios to ensure we are well positioned if interest rates move up or down. By doing this, we can optimise and create a margin of error to see if we can beat inflation.

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In Summary

We think investing in Fixed Income requires a detailed process - beyond simply picking deposits or bonds with the highest yield to beat inflation. Investors need not only think about returns, but also liquidity and investment horizon as well. 

Our investing philosophy within fixed income is to protect investors’ wealth against inflation, whilst taking into account liquidity. We believe we can help many investors achieve this objective through our Fixed Income-focused Reksa Dana, which we are excited to share more about with you soon.

Reksa Dana are able to allocate funds to (1) negotiate better rates with banks; (2) select bonds depending on the investment products’ time horizon; and (3) manage liquidity needs for investors.