Independent Research and Policy Advocacy

Inflation Indexed Bonds – Is it a good investment option in its current form?

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In line with Budget announcement by Finance Minister in February, Reserve Bank of India (RBI) announced to issue INR 12,000 crore to INR 15,000 crore of inflation indexed bonds (IIB) on 4th of June of the current year (2013). The proposed issuance is available for bidding to institutional as well as retail and mid-segment investors. The non-competitive segment would be 20% in order to encourage the retail participation. Further RBI envisages opening this product exclusively for retail offering in its proposed second issuance in October.

The coupon rates will be determined by auction of bonds, that’s why RBI is intentionally offering it to institutional investors to determine the pricing of these bonds in the first round. Real coupon rate will be applied to inflation adjusted principal to calculate the periodic semi-annual coupon payments. Further, the principal repayment at maturity would be inflation-adjusted principal amount or its original face value whichever is greater, thus there exists an inbuilt hedge for capital protection. However, these protections would be provided with respect to Wholesale Price Index (WPI) with four weekly averages of four month lag. This means that the hedge may not be perfect if the actual inflation rate differs from the WPI, which is likely to be the case for the retail investors. Also, the IIBs may not be sufficiently liquid; in general the long term debt market in India suffers from lower investor base and lower liquidity. This coupled with the 10 year tenure of initially offered IIBs may not make this an attractive instrument for the retail investors. However, the option to invest indirectly in IIBs through the investment funds (e.g. mutual funds) may provide a solution to the liquidity problem.

The issuance of IIBs by the government of India may be termed as a plan to borrow under the garb of protecting the retail investor from increasing prices or reducing the trade deficit by offering IIBs as an option in place of gold. Nevertheless it is a great step towards long term debt market reforms. RBI has mentioned that it may consider in future moving from WPI to consumer price index (CPI) once the latter is stabilized. Unless the issues of benchmark inflation rate and liquidity are addressed, the IIBs may not be an attractive investment for the retail investors.

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5 Responses

  1. How important is retail participation per se? If institutions
    participate and provide retail customers inflation-indexed products, doesn’t it
    meet the same purpose?

    1. Dear Bindu, thanks for your comment.
      I agree that indirect participation would serve the purpose to a great extent. Also, participation through investment funds may have several benefits to the retail investors, e.g. diversification across maturities, minimum investment size and reinvestment of interest income. However, as Bama mentioned in an earlier comment, the cost structure of the funds becomes an important factor as it may undermine the returns. Further, it would depend on to what extent the benefits of having a diversified investor base with differing risk appetite, investment horizon and investment purpose (hedging or speculation) could be realized through indirect participation.

  2. RBI has cleared that IIBs will not have tax sops. But when invested in mutual funds, whether the phantom income (adjusted principal) will be treated as dividend and subject to higher dividend distribution tax (DDT) from June 1, 2013 becomes an important aspect to look in for. It would be time for SEBI to look in to such case. Else, liquidity would be a trade off for dividend tax.

    Moreover another aspect to debate would be whether using the average WPI prior to four months to determine the reference WPI is appropriate. When the interest payout is semi-annual, why use a quarter scale to reference WPI?

  3. Good initiative by RBI and more importantly the timing of the issuance, just in the time when WPI figures are quite stable.

    More rigorous check on Anti-Inflationary Monetary and fiscal Policy is going to be very important because if this is not properly managed, it might result in a death spiral for the economy(say, the bonds are held up to maturity and inflation increases rapidly). So the success of this investment option will depend on how serious the government look at the inflation figures and taming it.

    Unlike US TIPS, RBI uses WPI instead of CPI which is also going to be a major discouraging factor because currently while WPI is reduced by 5%, CPI still hovers around in double digits.

  4. Thanks Bama for your comments; you have raised some very pertinent questions.
    The comparison between IIBs and TIPS is inevitable. The key difference is the indexation. The proposed IIBs are indexed to the final WPI with a four month lag. Whereas the Treasury Inflation-Protected Securities (TIPS) in US are indexed to “All Items Consumer Price Index for All Urban Consumers” (CPI-U) with a three month lag. Currently IIBs will be issued only with 10 year tenure. TIPS are issued with three tenures: 5 year, 10 year and 30 years.
    The returns and gain due to principal adjustment in TIPS are subject to federal tax (but exempted from local and state tax). IIBs too will not enjoy any special tax treatment. The semi-annual coupon payments and increase in principal due to inflation adjustment are taxable. However, if the securities are held for more than a year then the capital indexation benefits may be claimed.
    IIBs in the current form may not provide an efficient hedge against the inflation as the securities are indexed to WPI. However, if we ignore the indexation problem and assume for a moment that IIBs are linked to a better index (say CPI), then these securities may have advantage over gold (or other commodities) as inflation-protection-instruments due to the higher volatility of the latter. The average annualized volatility on TIPS portfolio has been around 5% for last 15 years, whereas for gold it has been substantially higher (more than 20%).

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