Not Bonding Well

The Reserve Bank of India last month had extended the date for the issuance of inflation indexed bonds. The subscription, which was earlier open between December 23-31, 2013 has now been extended till March 31, 2014. One of the reason for granting such an extension is the poor response that the scheme received from investors. However, officially no reason has been attributed for the extension granted. There surely ought to be other reasons too that have led to such a gloomy response to the issue. But before getting into them, let us understand the instrument and its features.

WHAT ARE INFLATION INDEXED NATIONAL SAVING SECURITIES – CUMULATIVE (IINSS-C) 

Inflation Indexed National Saving Securities – Cumulative (IINSS-C) bonds are primarily launched to protect retail investors from inflation and therefore its returns are linked to retail inflation or the Consumer Price Index(CPI). There are two components to the interest rate on these bonds. One is fixed and the other is linked to the CPI. The fixed component is 1.5 per cent per annum and one based on CPI will remain as a variable component. For instance, if CPI is 10 per cent, the interest payable will by 11.5 per cent (1.5 per cent + 10 per cent). The interest amount will be accrued and compounded in the principal on a half yearly basis and will be paid at the time of redemption. 

The interest rate will be reset after every six months to take into account the change in inflation rate. The maturity period for this bond is ten years and only after that can investors get their principal along with the interest amount. Although there is a provision of early redemption, that attracts a penalty. For senior citizens, defined in this case to be anyone above the age of 65 years, redemption is allowed after one year, while for others it is three years. The penalty amount is half of the last payable interest amount. So, if the last interest payment amounts to Rs 5000 then Rs 2500 will be the charged as a penalty. Interest on bonds will be taxable under the Income Tax Act of 1961. The minimum amount an investor is allowed to invest is Rs 5000 with the maximum limit standing at Rs 500000. Investors can invest through the authorised banks, which in this case are SBI and its Associates, all Nationalised Banks, HDFC Bank, ICICI Bank, and Axis Bank and the Stock Holding Corporation of India (SHCIL).

UNDERSTANDING THE CALCULATION 

The salient features of the bond clearly show that just like its name, calculation of returns on them is a bit complex. Unlike many other bonds where principal and coupon are almost fixed, in case of IINSS-C both vary. The interest rate as we mentioned above will depend upon the CPI, however, 1.5 per cent will remain as the fl oor rate. Therefore, in case of deflation of 4 per cent, interest rate will not be negative 2.5 per cent (-4 per cent+1.5 per cent=-2.5 per cent) but will remain at its floor rate of 1.5 per cent. As the interest amount keeps on accumulating and gets added to the principal, the principal amount too keeps on changing every six months. 

In the above example, you can see that if an investor invests Rs 5000 at the start of the year 2014, how his principal amount and interest rate will keep on changing and what is the final amount he will get after ten years when the bond matures. As demonstrated, there are two periods when the CPI dipped below zero or in other words we saw deflation, during January-July 2017 and January-July 2018. In both these periods the interest rate remained at a minimum guaranteed rate of 0.75 per cent. 

WHOM IS IT SUITABLE FOR? 

The bond is primarily launched to channalise the savings of domestic savers that gives them protection from the vagaries of high inflation and keeps their purchasing power intact. Currently, that maximum interest rate payable on any fixed deposit for five years is not more than 10 per cent. Compare this with the CPI that has been hovering in double digits for a while now to have moderated only in the month of December (9.87 per cent). So, effectively domestic savers are losing their purchasing power due to higher inflation and lower fixed deposit rates.

KEY POINTS:

• IINSS-C are launched to protect domestic investors from higher inflation  
• The interest rate consists of fixed (1.5 per cent) and variable (CPI inflation) component  
• This a good investment opportunity for someone who is young, lying in lower tax bracket and does not have immediate need of the liquidity.

The bond looks attractive when compared to investment in fixed deposits where similar tax rates are applicable to interest accrued. However, if we include the tax component in the overall calculation of returns, we find that the bond loses its attractiveness particularly for those who fall within the higher tax bracket. Moreover, as maturity period of the bond is 10 years and any early redemption attracts penalty and there is no interest payment at regular intervals, it looks unappealing to many senior citizens.

We have already witnessed a lukewarm response to the issue (due to which the issue date was extended) and hence we feel that government should consider adding some more features to make it more attractive. For example, giving a tax rebate on interest that is available with other instruments like PPF, five year fixed deposits, etc may make it an attractive investment destination for many. In addition to this, the early redemption options without attracting heavy penalty will also make it more appealing.

Therefore in the current format, this bond is a good investment opportunity for someone who is young, lying in the lower tax bracket and does not have immediate need of liquidity.