Real return on bonds

Chapter 7 of Finance 101 established that money sitting still loses value. This chapter applies it to the asset class that looks least like it has a problem.

The defect in a fixed promise

Chapter 1 called the fixedness of a bond its best feature: you know what arrives and when. That is true and it is also the whole vulnerability.

A ₹1,000 bond paying 7% hands you ₹70 a year and ₹1,000 at the end. Those are nominal rupees. If prices rise 6% a year over ten years, the ₹1,000 that comes back buys roughly what ₹558 buys today. The borrower kept every term of the contract. You are still worse off than the numbers suggest.

Equity has no such defence either, but it has a mechanism: companies raise prices, revenues grow with the price level over long periods, and earnings can follow. A coupon cannot. The contract says 7% and 7% is what it says in year ten.

The two subtractions, in order

The order matters, and getting it wrong flatters the result.

Start with a 7.5% bond, a 30% marginal rate, and 5% inflation.

Tax comes off the nominal interest. Chapter 10: interest is taxed as income from other sources at your slab rate, charged on the whole ₹75, not on the part that beat inflation.

after-tax yield = 7.5% × (1 − 0.30) = 5.25%

Then inflation.

real after-tax return ≈ 5.25% − 5% = 0.25%

A quarter of a percentage point. The headline said 7.5%, and after the two subtractions almost nothing is left.

That is not an exotic scenario. It is an ordinary deposit, an ordinary tax rate and inflation inside the band the RBI targets.

Why tax makes inflation worse than it looks

Worth isolating, because it is the part people miss.

The tax is charged on the nominal return. In a world with 5% inflation and a 7.5% yield, only 2.5 points of that yield is real — but you are taxed on all 7.5. So the effective tax rate on your real return is far above your marginal rate.

At a 30% marginal rate the tax takes 2.25 points out of a 2.5 point real return. That is a 90% effective tax on the only part that mattered.

Higher inflation makes this worse even if yields rise to match, because the tax is levied on the larger nominal number. Inflation and taxation interact against the saver, and the interaction is invisible in every quoted yield.

What this means for how you use fixed income

Not "avoid bonds". Something more specific.

Fixed income is for certainty, not for growth. Its job is money that must be there on a date — the emergency fund of chapter 4 of Finance 101, a deposit due next year, money you cannot afford to see fall. It does that job better than any other asset. Expecting it to build wealth over decades is asking it to do something its structure cannot.

The long holding is where the damage is. One year at a 0.25% real return costs nothing. Twenty years of it means your money bought almost exactly what it bought at the start, having felt safe throughout. Chapter 8 of Finance 101 runs the same compounding in the other direction.

The safest-looking choice carries the slowest loss. This is the honest summary. A bank deposit cannot fall in nominal terms, which is why it feels safe, and the certainty it offers is certainty about a number rather than about what the number buys.

Where a real yield can be had

Three observations, without recommending anything.

Real yields are sometimes genuinely positive. When yields rise faster than inflation, fixed income offers a real return after tax, and that is a materially better moment to lend long. The yield curve of chapter 9 against current inflation tells you which world you are in, and it is free to check.

Instruments linked to inflation exist, and they shift the risk rather than remove it. Their terms vary and they are worth reading carefully rather than assuming.

Tax treatment varies by instrument more than yield does. Chapter 10's point: two instruments with the same pre-tax yield can leave very different amounts with you. That difference is often larger than the yield difference you were shopping on.

The point

A fixed coupon cannot respond to prices rising, and tax is charged on the nominal interest rather than the real part — so a 7.5% yield at a 30% rate with 5% inflation leaves about a quarter of a point. Fixed income is the right asset for certainty about a date, and the wrong one for building wealth over decades.