Understanding Inflation Indexed Bonds

This post is written by Shiv Kukreja, who is a Certified Financial Planner and runs a financial planning firm, Ojas Capital in Delhi/NCR. He can be reached at skukreja@investitude.co.in

Budget 2013 had “next to none” changes for the Indian taxpayers, investors or savers. As far as the investment options are concerned, some minor changes were made in the Rajiv Gandhi Equity Savings Scheme (RGESS) and a new kind of bonds got proposed to be introduced from June 2013.

Most of you must be aware about it by now, these are Inflation-indexed bonds (IIBs) or inflation-indexed national security certificates which will link their capital appreciation to inflation rates.

High inflation has left Indian investors earning negative real interest rates and that ways, it has reduced their purchasing power also. Investments by Indian households in financial instruments have also dipped to its record lows in the recent times. IIBs, by definition, are meant to provide protection against inflation to its investors.

The basic idea behind launching these bonds is to incentivise Indian household sector to invest in financial instruments rather than buy gold and thereby hedge the investors’ investments against high inflation and lower the gold demand here in India.

As per the Economic Survey of 2013: “Gold is considered as a hedge against inflation. Investors, especially in the middle-class, invest their savings in gold, which, in turn, has created a huge demand for the yellow metal. This necessitated imports, resulting in foreign exchange outgo, causing concerns for the RBI and the government. Like gold, the investment in IIBs would help hedge against inflation.”

India is the largest importer of gold in the world as people have a charm of owning it as jewellery and they also have a view that the gold prices always increase over a period of time, even if there is a small fall in its prices in the short term.

India imports a large percentage of its gold consumption and makes payments in foreign currency for the same. A rise in gold demand and its imports results in a rise in demand for dollars which is a big negative factor for our economy as it results in a fall in the value of Indian rupee and a higher current account deficit (higher imports – lower exports). Ultimately, it results in even higher inflation.

IIBs are not new to the financial markets. The RBI had introduced inflation-indexed bonds some years ago, which, however, did not take off due to poor response. It was then decided to re-design the instrument.

RBI has been advocating the re-introduction of IIBs for quite some time now and it also brought forward a technical paper on IIBs in October 2010.

IIBs – Good for the Govt.

IIBs benefit both the investors as well as the issuers. Research suggests that during inflationary periods, the government’s weighted average cost of market borrowings through IIBs would be cheaper in comparison to nominal dated securities and thus it would be able to raise its required borrowings in a cost effective manner. It also suggests that the nominal interest payouts would be in line with the revenues of the government, leaving minimum mismatches on account of inflation.

Also, if the government succeeds in its attempt to attract a portion of investors’ money invested in gold or gold-linked instruments towards these IIBs, then it would reduce our import bill to some extent.

Structure of Inflation-Indexed Bonds

First tranche of Series I IIBs will be issued by the RBI on June 4, 2013 and it will carry a fixed real coupon rate which will be announced by the RBI in due course. The principal on the IIBs will be indexed to inflation and the coupon will be calculated on the indexed principal. So, the investors will receive inflation-adjusted interest payments periodically on the indexed value of their initial investment.

At the time of maturity also, the investors will get inflation-adjusted principal repayments or their original principal investments, whichever is higher.

Unlike many other countries where the CPI is widely used, the RBI has decided to use the final inflation numbers based on the wholesale price index (WPI) for setting the coupon rate on IIBs. As per the RBI – “Unavailability of a single CPI representing the consumption basket of all sections of society in India renders it impractical to be used in indexation of IIBs”. In the past also, WPI was used for indexing the capital indexed bonds (CIB) wherein principal was indexed at the time of redemption.

RBI has also announced that the final WPI inflation numbers with four months lag will be used as the reference WPI inflation. This is because many a times final WPI deviates widely from the provisional WPI, with even directional changes.

At present, the Office of the Economic Adviser, Ministry of Commerce and Industry, GoI releases the ‘provisional’ inflation numbers based on WPI with a lag of two weeks and ‘final’ inflation numbers based on WPI with a lag of two and a half months. For instance, provisional inflation numbers for May 2013 and final inflation numbers for March 2013 would get released on June 14, 2013. So, for indexation purposes in IIBs, final WPI inflation of May 2013 and June 2013 will be used as the reference WPI inflation for 1st October, 2013 and 1st November 2013, respectively.

How exactly it works

For example, assume an IIB issued at a face value of Rs. 1000 with a real coupon rate of 3% paid annually. If the annual inflation comes out to be 5% at the time of coupon payment, the principal of the bond would be re-calculated as Rs. 1050 and the coupon payment would be Rs. 31.50 i.e. Rs. 1050 * 3%.

Inflation-Indexed Bonds (IIBs):

Face Value: Rs. 1,000

Real Coupon Rate (or Inflation-Adjusted Coupon Rate): 3% per annum

Inflation at the time of Coupon payment: 2% or 5% or 8% (Three Scenarios)

Coupon Payment (in Rs.): [1,000*(1+2%)]*3% = Rs. 30.60 (or 3.06% on Rs. 1,000)

Coupon Payment (in Rs.): [1,000*(1+5%)]*3% = Rs. 31.50 (or 3.15% on Rs. 1,000)

Coupon Payment (in Rs.): [1,000*(1+8%)]*3% = Rs. 32.40 (or 3.24% on Rs. 1,000)

On the contrary, if there is a deflation of 2%, the indexed principal would be Rs. 980 and the coupon payment would be Rs. 29.40 i.e. Rs. 980 * 3%. However, at the time of maturity, as the principal to be received back can’t be less than the original face value of Rs. 1000, so it would either be the face value of the bond i.e. Rs. 1000 or a higher market price.

Index ratio (IR): Index Ratio will be used for indexation of the principal amount and will be computed by dividing reference index for the settlement date by reference index for issue date (i.e., IR set date = Ref. Inflation Index Set Date / Ref. Inflation Index Issue Date).

Tenors of the IIBs: First tranche of Series I will be issued for a tenor of 10 years, which is considered as the benchmark period in most of the dated securities. It is expected to have different maturities later on.

Issue Size: RBI plans to issue IIBs of Rs. 12000-15000 crore this financial year in various tranches and each tranche will be for Rs. 1000-2000 crore.

Reserved portion for Retail Investors: 20% of the issue size in the first tranche has been reserved for the retail investors. Series II of IIBs is expected to be announced in October, which will encourage exclusive participation from the retail investors.

At this juncture, it makes sense for the govt. to issue IIBs and it would help investors also in diversifying their asset portfolios. Moreover, investors will be able to participate in more productive assets rather than gold, which has cut down the financial savings dramatically. But, it remains to be seen how these bonds would evoke response from the investors this time around

Also read Deepak Shenoy’s post on Inflation Indexed Bonds as that has some good thoughts as well.


12 thoughts on “Understanding Inflation Indexed Bonds”

  1. Shiv – My comments may perhaps be out of place here. I still would air my views to compare long term investment in gold, equity and debt.

    Media keeps upon harping about investment in equity to be the best option. If you compare the worst case scenario of investment in Harshad Mehta time (1991) and today, the index has moved about 4.5 times to 20,000 today i.e. 4.5 times in 21 years. Equity investment made in 2008 has not given any gains.

    Gold was Rs 4,000 in 1992 and has moved to 26,000 today. It looks large because of depreciation of Indian Rupee. In international market it has moved barely 3.5 times from $400 to $1350 – $1400 in 20 years. No expert talks of heavy premium that one has to pay to buy gold. It ranges from 10 – 15%. Electronic form of gold may be little better but there also some charges are involved.

    If you compare these with debt, you double your money in 10 years (worst case @ 7% p.a.) or 3 times (best case @ 10% p.a.)

    Summarising, I do not see much difference among the above. I would recommend debt for individuals who cannot spend much time to transact on almost daily basis. Though money is important, I always have been of the opinion that “life is not economics”. Continuously thinking about money otherwise makes you dull and drives you away from your intellectual skills and abilities.

    I am skeptical if Index based bonds are of any use for the common man. They will at the most ensure that value of your money is retained. But then our price indexes are calculated on the basis of cost of rice and sugar. These things were important for generation that lived say in 20th century, not now. in last decade or two alone, India has moved much beyond rice and sugar. The rate of change will move up exponentially.

    Your comments, Shiv?

    1. I think these inflation-indexed bonds are not going to be something “very special” for the investors and its introduction is ill-timed also, but still it is a welcome move. I dont think it is govt’s job to keep introducing products with highest returns. I think the higher expectations you have out of something, the more hurt you’ll feel if it doesnt meet your expectations. Human wants are endless, from having rice & sugar to owning all the luxury items on this earth to stepping into God’s domain, it is a never ending story. The problem with the retail investors is that they are not rational and dont use their brains in the right direction.

      Not everybody can expect to become multi-millionaire overnight by investing in stocks or real-estate or gold or commodities. I also think that the investors should have a greater allocation towards equity investment, as it gives way better returns than debt & gold. Equity investment is volatile and if it is made in the wrong companies and that too at a wrong time, it is very very painful. But, at the same time, it has the potential to reward its investors very handsomely, if done smartly in a wise manner. People earn 7-10% returns on their debt investments when they lend it to the corporates which in turn use it to earn potentially higher returns for their shareholders.

      I dont ask airline companies to let me fly a plane if I dont know how to do that, then why dont retail investors leave it to the fund managers to manage their money, if they dont have the required expertise and time.

      It was easy for the investors in 2003 to foresee stock markets rallying and thereby making money out of it. Markets moved up from 3,300-3,500 to 21,000 (nearly 6 times) in less than 5 years. I dont know how many people were able to do that. It was easy for the investors 5-7 months back to predict interest rates falling & bonds rallying, how many investors switched their money into long-term gilt funds or income funds? Now, when they have already rallied, people will start enquiring about it once the newspapers/websites have stories about their returns all over the places.

      I agree with you that “life is not economics” but the problem is that people do not live it as life. They themselves make it complicated. People smoke cigarettes and burn crackers on Diwali even as they know both are injurious to health and a total waste of money. After all, it is their life. No ??

      1. Well said Shiv, especially the last para. I find your words to be conveying more than what you write. I would have made your life miserable if I was Delhi based. You are lucky I am only 200o Km away

          1. Shiv = Thanks. May I request you something. The falling interest scenario offers certain investment opportunities in debt. FMPs are one option in this regard. I am not sure if you enlightened your readers in this regard. If yes, activating old article as such or with update based on present market condition would be useful to your readers. If no, pl write an article.

  2. Thanks Shiv.

    At maturity if the principal increases, will the excess be part of the capital gains? How does it compare with the tax free bonds we have bought at say 8+% interest two years back? Both of these instruments don’t compound the interest while the tax free bond interests are tax free.

    1. Hi Bhaskar… nothing has been announced as yet as far as the treatment of maturity proceeds are concerned, but I think it should be tax-free. I think so because even if the govt. decides to give it the treatment of debt funds, it would be 20% capital gain tax with indexation and when you are already applying indexation on its principal value, then your capital gain would be zero.

      Also, I think tax-free bonds are superior than these bonds if bought at a higher yield like 7.5-8%+ and when you expect the interest rates to fall. When you expect interest rates to rise, then IIBs can protect your principal investment.

      1. Thanks Shiv. Its good there are new instruments applicable to retail junta coming in the market. Govt should make them simple to invest and transact in. Thanks for the nice post.

        1. Thanks Bhaskar! Ya, it is good to have these kind of instruments in the markets for the retail investors. But, at the same time, it is sad that govt. always act as late as possible to introduce these products and make them equally complicated to invest in them. Look at RGESS, NPS and even mutual fund KYC for that matter.

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