Inflation-Indexed Bonds: Will They Be Game Changers?

The government is all set to issue inflation-indexed bonds, which are designed to help individuals tackle the threat that volatility poses to their investments. Hemant Rustagi tells you more about these bonds and whether retail investors can really benefit from them.

In the Union Budget 2013, the Finance Minister had announced the introduction of inflation-indexed instruments to tackle the Current Account Deficit risk to the economy. These instruments were expected to wean investors away from gold. Another objective behind introducing these instruments was to safeguard the savings of poor and middle classes against inflation.

Consequently, the Reserve Bank of India (RBI), in consultation with the Government of India, decided to launch inflation-indexed bonds (IIBs). The first tranche will be issued on June 4, 2013. Subsequently, IIBs will be issued regularly through auctions on the last Tuesday of each month during 2013-14. Each such tranche will be of Rs 1000-2000 crore, and the total issuance during the financial year is likely to be around Rs 12000-15000 crore.

Retail investors often find it difficult to tackle volatility, which is an integral part of equity investing. Besides, not many investors realise the importance of earning a positive real rate of return as they do not sufficiently appreciate the threat of inflation to their investments. However, with the advent of IIBs, there is likely to be a growing awareness amongst the investing public in this regard.

Before analysing the impact of IIBs on an individual investor’s ability to tackle inflation, let us take a look at what they are and how they work. IIBs are bonds in which the principal is linked to inflation. In other words, they are designed to cut out the inflation risk of an investment. The introduction of IIBs is certainly good news for investors, as these bonds will allow them to tackle inflation without having to overstep their risk taking capacity. Hitherto, investors usually had to rely on an asset class like equity and gold to enhance their chances of staying ahead of inflation.

IIBs were first issued in the UK in 1981. In India, this is the third attempt of the government to issue IIBs. Prior to this, such bonds were issued in 1997 and 2004. However, the response had remained lukewarm as the structuring was poor.

This time around, the coupon rate will be fixed throughout the tenure of the bond. The principal amount will be adjusted against inflation and interest will be paid on the adjusted principal. Thus, these bonds provide inflation protection to both principal and coupon payment. At maturity, the adjusted principal or the face value, whichever is higher, will be paid.

Let us understand how the interest will be calculated. For example, assuming that the annual coupon rate is eight per cent and the principal is Rs 100, the investor will be paid Rs 8 a year. In case the inflation index rises to 10 per cent, the principal will become Rs 110. The coupon rate will remain eight per cent, resulting in an interest payment of Rs 110x8 per cent, i.e. Rs 8.80.

These IIBs will have a tenure of 10 years and the interest will be payable every six months. However, retail investors will get an opportunity to invest in the bonds only in October 2013. To attract retail investors, around 20 per cent of the bonds will be reserved for them.

The response from retail investors will depend upon the coupon rate. If the coupon rate is lower than that of other bonds, retail investors may not be enthusiastic about subscribing to them. Besides, the Wholesale Price Index (WPI) will form the basis for determining the payments to investors. This in no way will protect retail investors’ savings from inflation, as they are impacted more by the Consumer Price Inflation index (CPI).

Another important aspect from the retail investors’ point of view would be liquidity. Although IIBs will be traded on the secondary market like other debt securities, they may not provide adequate liquidity to retail investors. Besides, the interest earned on IIBs will be taxed as in the case of other bonds. Therefore, with lower post tax returns, investors in the higher tax bracket will find it difficult to earn a positive real rate of return.

Considering that one of the key objectives of the government for launching IIBs was to target those investors who invest in gold, it will be difficult for these bonds to provide a perfect alternative. While IIBs are a welcome addition to the investment universe of investors, their effectiveness will be seen over time.

Hemant Rustagi
CEO, Wiseinvest Advisors