India has been struggling with a quite high level of inflation, both at the wholesale level and even higher at the consumer level. While wholesale price inflation is hovering at around 7.52%, high vegetable prices have pushed the consumer price inflation to 11.24%.
With 11.24% retail inflation and 9% (or below) taxable return on deposits, we are earning a negative return and the purchasing power of every rupee we are earning and saving is actually getting eroded.
To enable us earn slightly more than the retail inflation, the Reserve Bank of India (RBI) will issue Inflation Indexed National Saving Securities (IINSS) from today i.e. 23rd of December.
The issue is scheduled to remain open only for seven working days i.e. till December 31st, but the government reserves the right to preclose the issue even before this scheduled closing date. Moreover, the government has not announced the quantum of money it wants to raise from this issue.
What are these bonds and who is going to issue them – the RBI or the Government?
It has been raining bonds for the past four months but this bond issue is different from the earlier issues in many of its features. These are the bonds which would be linked to the consumer price index (CPI) inflation and though the bonds will be issued by the RBI, it would be the liability of the government of India to pay you the interest payments as well as the principal investment at the time of maturity. That ways you can call these bonds a risk-free investment.
Rate of Interest – These bonds will carry interest rate which is not fixed in advance and would be inflation-linked, as the name suggests. In practical words, these bonds will earn half-yearly interest rate which would be calculated by adding 0.75% to the semi-annual CPI inflation.
e.g. if the CPI inflation is 150 today and it is 157.5 six months later, then the investors will earn 5.75% semi-annual return (5% semi-annual inflation + 0.75% fixed rate) and Rs. 1,00,000 invested today would stand at Rs. 1,05,750 at the end of six months.
CPI inflation, which is to be taken into consideration as the reference inflation, will be used with a lag of three months. e.g. September 2013 CPI inflation will be used as the reference CPI inflation for the month of December 2013, when your investment is getting started and March 2014 CPI inflation will be used as the reference CPI inflation for the month of June 2014, when your first due interest will get accrued and get added to your principal investment amount.
Also, this fixed rate of 1.5% would also act as a floor in case the CPI inflation turns negative anytime during its tenure of 10 years.
Interest Payment – These bonds have been named as “Inflation Indexed National Saving Securities – Cumulative, 2013” and here ‘Cumulative’ itself makes it clear that no intermediate interest payments will be made to its investors. There is no such provision to get monthly, quarterly, semi-annual or even annual interest payments with these bonds.
Interest will get compounded semi-annually and will be paid only at the time of maturity along with your principal investment amount. Investors, who want to earn a regular income from their investments, would stand disappointed with these bonds.
Taxability & TDS – These bonds are inflation-linked, but not tax-free. The government is not going to leave its share of taxes and not just only 1.5% fixed interest, the whole interest earned on these bonds would be taxable as per the tax slab of the investors.
But, whether it would be taxable annually or at the time of maturity, it is still not clear to me at present. I think it should be taxed annually, in a similar way the Post Office National Saving Certificates (NSCs) get taxed.
Still one thing is clear, that there won’t be any TDS on the interest payable. Though personally I am not in favour of TDS not getting deducted on any taxable income, as it gives a chance to the tax evaders to get away with it, I think it is a good thing for the investors.
Who is eligible to invest? – Indian retail investors, including individuals, HUFs and specific charitable institutions and universities are eligible to invest in these bonds. Non-resident Indians (NRIs) are not eligible to invest in these bonds, but an investor can nominate an NRI as his/her nominee.
Investment Process – Investors, willing to invest in these bonds, need to approach SBI or its associate banks, other nationalised banks like PNB, Bank of Baroda, Canara Bank, IDBI Bank etc. or private sector banks – HDFC Bank, ICICI Bank, Axis Bank or Stock Holding Corporation of India.
All the formalities, including form availability, acceptance of investment cash/cheque/demand draft/e-transfer, Know Your Customer (KYC) verification, registration of the customer on the RBI’s web-based platform (E-Kuber) and generation of the Certificate of Holding, will be done by these banks.
To compensate these banks for their services, the government has decided to pay 1% of the subscription amount they get mobilised.
Minimum & Maximum Investment – These bonds will carry a face value of Rs. 5,000 and an investor will have to subscribe for at least one bond to invest in these bonds. Maximum investment limit has been set at Rs. 5,00,000.
Lock-in period, liquidity & premature redemption – These bonds will carry a lock-in period of one year for the senior citizens aged 65 years or more and three years for all other investors. Also, these bonds are non-transferable and non-tradable on the stock exchanges, so you cannot sell them to any other investor during their tenure of 10 years.
But, you can redeem these bonds back to the RBI after the lock-in period gets over and that too, only on the coupon due date. To redeem these bonds, you’ll have to forego 50% of the last coupon payable as penal charges.
Bonds as Collateral – If you have an urgent but temporary requirement of funds, then you can use these bonds as collateral against loans from banks, financial institutions and other non banking financial companies (NBFCs).
Historical Chart of CPI Inflation
Just check the chart above. It is the 20-year chart of India’s historical inflation based on the consumer price index (CPI). For a good period of time in the last 15 years i.e. from July 1999 to January 2008, the retail inflation remained below the 5% mark. Also, whenever it crossed the psychological mark of 10%, the stay was for a very short period of time and it had an equally sharp reversal.
So, how long we will stay above this important level this time around, it would be quite interesting to observe. If the inflation again falls sharply this time also, like it has happened many a times in the past, then the investors would find themselves trapped with this investment.
Illustrative Examples of Inflation Indexed National Saving Securities (IINSS)
Example I: After-Tax Cash Flow Analysis with calculation of NPV and IRR
Using the financial calculator for a cash flow analysis of this illustrative example, I got Rs. 5,979 as the Net Present Value (NPV) and 7.2557% as the Internal Rate of Return (IRR).
Example II: After-Tax Cash Flow Analysis with calculation of NPV and IRR
Again, with this illustrative example, the Net Present Value (NPV) comes out to be Rs. 3,598 and the Internal Rate of Return (IRR) is 5.0909%.
So, if I compare these two rate of returns with the current coupon rates of tax-free bonds, then it is clearly evident that tax-free bonds seem to be a better investment option. But then these are just illustrative examples and the actual inflation numbers would be quite different from these assumed figures.
Investors, who are not liable to pay any tax on their current income and also on their future income or who fall in the 10% tax bracket and who also think that inflation is not going to come down at least for the next 3-5 years, should definitely subscribe to these bonds.
Due to its unfavourable tax treatment, lock-in period of 3 years, 50% deduction of last year’s due interest in case of premature withdrawal, high uncertainty about inflation and no scope of any capital appreciation, I would personally avoid these bonds and go for the tax-free bonds for my investments.
Also, I could not work on a comparative analysis of these inflation-linked bonds with tax-free bonds in this post, but I would definitely like to do that as soon as possible. I would also like to have some inputs from your side so that all possible points of comparison can be covered and we can reach to a healthy conclusion out of it.