Understanding money illusion and investment in bonds
Money illusion refers to the tendency of people to think of money or price in nominal terms rather than in real terms. It is the confusion of nominal values with real ones.
A nominal value is an unadjusted economic value expressed in monetary terms. By contrast, a real value is the value that has been adjusted to reflect the change in general price level over the period. Basically, nominal value reflects how much money you have whereas real value reflects how much is your money worth. Money illusion is when one confuses how much one have with how much it is worth.
Consider two scenarios (everything else being equal):
Scenario A: Your employer gives you 5percent raise when inflation runs at 7percent
Scenario B: Your employer gives you 2percent raise when inflation runs at 1percent
Which one would you prefer?
If you prefer Scenario A, you fell into the trap of "Money Illusion". Although in Scenario A, you get more money in nominal terms, the purchasing power of your money is eroded by inflation and you are actually worse off in real terms. In Scenario B, although your raise is lower in nominal terms, it is still higher than the inflation rate and you will be better off in real terms.
The distinction between real and nominal value is crucial in the field of investments. What matter most is not your return in nominal terms but in real terms. In simple terms, real return is the difference of nominal return and inflation rate. Real return is what gives you a higher purchasing power and thus, increase the value of your investment.
Real Return = Nominal Return - Inflation Rate
Suppose A has 1,000 with him which he can either use for consumption or investment. If he uses it for consumption today, he will get 1,000 worth of goods. However, he decides to invest now and consume a year later. As such, he invests 1,000 in stocks and gets a return of 20 percent with the inflation at 10percent. By the end of the year, he would have 1200 with him in nominal terms. However, due to 10percent inflation, the prices of goods have gone up by 10 percent. Now, to buy the same amount of goods he could have bought a year earlier with 1000, he requires 1100. As such, only the remaining 100 was his real return (10percent of the investment).
That brings us back to the investment in bonds -- both government as well as corporate. In international markets, investors invest in bond to diversify their portfolio since they are safer than stocks as well as provide higher returns than savings and fixed deposit accounts. If used properly, it is a good investment tool and can be used to hedge against the ups and downs of the stock markets.
However, in the context of Nepal, the risk-return ratio of investment in bond is a bit tricky for three reasons:
1. Investment in bond is losing value in real terms:
The latest bond issued by Nepal Rastra Bank (NRB) was "National Saving Bond 2075" with coupon rate of 8percent and "Foreign Employment Bond 2075 Kha" with coupon rate of 9 percent. On the corporate side, NIC Asia Bank issued "NIC Asia Bank 2077" with coupon rate of 7.25 percent and Nepal SBI Bank issued "7.9 % Nepal SBI Bank limited Debenture 2080" with coupon rate of 7.9 percent.
The Asian Development Outlook 2014 released by Asian Development Bank projected that inflation in Nepal would remain at 10 percent in this fiscal year (2070/71) and 9.5 percent in the following year (2070/71). As such, if you are investing in bonds with coupon rate less than 10 percent, you are actually loosing the value of your investment in real terms. If you have invested in "National Saving Bond 2075", you lose 2percent of the value of your investment in real terms this year and if the prediction of ADB is to be believed, further 1.5percent next year, and so on.
2. Investment in bond is adding risks without adding higher returns:
No matter how good an organization issuing bond/debenture is, there is some inherent risk associated with it. So, when one is investing in bond, one is taking some risk to get a return of 7 to 9 percent. However, since deposits up to 200,000 in financial institutions is guaranteed by Deposit and Credit Guarantee Corporation, they are relatively less risky than corporate bonds. If one look around, it is not hard to find institutions offering higher than 9percent interest on fixed deposits. Less risk and higher returns (for small and medium investors)!
3. Investment in private corporations is considered safer than that in government:
The return in investment is the direct result of the risk an investor is taking. As such, the higher the implied risk, the higher the implied return. Given the scenario where private corporations are raising money at a lower rate than NRB which is backed by the full faith of Government of Nepal, it implies that investors doubt NRB's ability to pay its loan more than that of private corporations.
This is not to say that one should stay away from investment in bonds (although finding an investment with low risk and return equal to or above inflation rate is advisable), but not to confuse nominal return from real return and fall into the trap of "money illusion".
- Anil Bikram Shah
Investment Analyst
anilbikramshah@gmail.com
