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Inflation Indexed Bonds

IIB or Inflation Indexed Bonds (also known as inflation-linked bonds or colloquially as linkers) are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780.

The RBI has finally got plans to introduce IIB’s in India as per Budget 2013 proposals. The primary trigger for the RBI to introduce IIB’s is to reduce the appetite for Gold for Indian investors, which is having a detrimental impact of the balance of payments.

Current Account Deficit

Tax Filing 14

The balance of payments and the current account deficit is a relatively macro-economic calculation; however they are an indicator of the financial health of the country in general. If the financial health of the country deteriorates, so does the currency value of the country and hence the imports become more expensive and this is a vicious cycle, as a country whose financials are weak will have to pay even more for imports and receive less for imports hence making its economy further weaker.

The import bill of a country includes many essentials, like crude oil which cannot be curtailed. However, Indian being one of the largest importer of Gold, a large percentage of the import bill for the country is for gold, which seems to be a non-essential import and the Government fees that the demand of gold consumption can be reduced by IIB’s to have a reasonable impact on the current account deficit.

Why Inflation Indexed Bonds

Traditionally, Gold has been used largely as an option for jewellery and for some savings. The returns historically have been close to the rate of inflation, or a little more or a little less, but close to the inflation rate. Hence out of a disposable saving of Rs 100 for a family, normally Rs 10-20 would have gone into Gold based instruments which again in 90% cases would be in the form of jewellery.

However, with the economic turmoil in the past 5 years and the unprecedented jump in Gold prices with a return averaging more than 20% per annum has brought Gold to become one of the principal pillars for investments and savings in a typical Indian household.  Now a investment of Rs 30-40 will be made into gold or jewellery from a disposable saving of Rs 100, and most of this investment is now in the form of ETF’s or gold coins or bars and not jewellery.

The trade deficit is $17.8 billion in April, 27% higher then the $14 billion in the same month last year. Imports were $41.95 billion, almost 11% up over $37.8 billion a year before. In April, gold imports alone were $7.5 billion, against $3.1 billion in the year-ago period. This constituted nearly 25% of all non-oil imports.

Imports of gold and silver jumped 138% in April, due to the Akshaya Tritiya festival, considered an auspicious occasion to buy gold.

The Government has finally sensed a need for an investment and saving options where an Indian household can park funds to hedge against inflation and in-turn substitute the increasing demand for gold. The proposed solution and option is an Inflation Indexed Bond.

Inflation

The IIB is expected to best suited for investors who are looking at security along with a hedge against inflation.

Due to inflation the value of money or the purchasing power of money reduces.

Inflation

If you bought 1 Kg of mangoes for Rs 100 today it would cost Rs 150 2 years down the line. Hence you buy the same amount but need to spend more. Another vice-versa example is if you got 1 kg of apples for Rs 100 now, after 2 year, you would possibly get only 0.6 kgs of apple for Rs 100.

This price increase over periods of time is called inflation.

 

 

Most investment options in India are not protected or hedged against inflation. Hence, suppose a fixed deposit or for that matter any other investment is say, earning you 8% per annum and the average inflation rate is 10% you are actually loosing 2% every year. Mind it, we are speaking of a tax free return and we off-course know that we have limited options to earn us a net 8% per annum (post taxes). Moreover the practical inflation is often more than 10%. Hence we are actually losing our money’s worth in a drastic rate.

Hence if you actually keep Rs 100 in your locker for 1 year, it is equal to Rs 90 after 1 year.

The inflation is measured by a ration called the WPI (Wholesale Price Index) and a CPI (Consumer Price Index).  Measuring the index figure involves large data churning and analysis. This price index is a number which indicates the average change in prices paid by a whole-seller or a consumer over a period of time.

IIB Workings

If you invest Rs 100000 in an IIB at say, an interest rate of 10% payable annually for an tenure of 5 years then the payout to the investor will be as follows assuming an inflation rate throughout the 5 years that the investment is held for, then the payout received by the investor will be as follows:

Year

Invested Amount

Interest Rate

Inflation Rate

Payout - IIB

1

100000

10%

6%

10600

2

100000

10%

5%

10500

3

100000

10%

8%

10800

4

100000

10%

9%

10900

5

100000

10%

9%

116900

     

Total

159700

Hence we see that based on the inflation for a particular year, the principal and the interest payout amount is adjusted and the interest is computed on the base coupon rate and the inflation rate using the adjusted principal amount.

On maturity, higher of the principal or the inflation adjusted principal is paid out.

If inflation rises by 5% over a year, the principal value of the bond will be raised by 5% to Rs 105000. At the 10% coupon rate, that will translate into an interest of Rs 10500 rupees for the year.

If inflation eases, the principal is lowered. So, if prices fall by 10%, the new principal will be Rs 90000 and the interest for the year will be Rs 9000.

Regular Bonds v/s Inflation Indexed Bonds

Now, we will see what is the difference between normal Bonds and Inflation Indexed Bonds.

Year

Invested Amount

Interest Rate

Inflation Rate

Payout - IIB

Normal Bond

1

100000

10%

6%

10600

10000

2

100000

10%

5%

10500

10000

3

100000

10%

8%

10800

10000

4

100000

10%

9%

10900

10000

5

100000

10%

9%

116900

110000

     

Total

159700

150000

In case of a normal bond the total interest receipts would have been a fixed Rs 10000 per year and the net inflow post maturity would have been Rs 150000. However in a IIB for similar variables, the inflow is Rs 159700 which is close to an extra of Rs 10000, almost a years interest.

IIB Features

The basic features of the proposed IIB’s as announced by RBI are:

> The IIBs would have a fixed real coupon rate and a nominal principal value that is adjusted against inflation.

> Coupon payments would be paid on adjusted principal. Hence, these bonds will provide inflation protection to both principal and interest payments.

> At maturity, the adjusted principal or the face value, whichever is higher, will be paid.

> At present, 2004-05 is used as the base year for WPI.

> To begin with, these bonds will be issued for a tenor of 10 years.

> Each tranche of IIBs would be for Rs 1000 – Rs 2000 crore and the total issuance would be for Rs 12000 – Rs 15000 crore in 2013 - 2014, RBI said.

> The returns would be calculated by using the rate of Wholesale Price Index-based inflation of the corresponding four months ago, it said. “Final WPI with a four-month lag will be used, that is September 2012 and October 2012 final WPI will be used as reference WPI for February 1, 2013, and March 1, 2013, respectively. The reference WPI for dates between February 1 and March 1, 2013, will be computed through interpolation,” said RBI.

Concerns

However, it is a little premature to determine whether the IIB will prove to be a boon for investors and for the Government alike as many features and variable are yet to be decided and may not go down well with the investors at large.

Few of the concerns over IIB’s are:

> Choice of WPI over the CPI, as CPI is a more realistic measure of inflation. The WPI is currently single digit where as the CPI is double digits.

>  The coupon rate that will be offered is expected to be lower than the normal banking channel coupon rates.

>  There are no tax benefits expected on maturity amounts and the interest earned.

>  Investor education and sales channel for retail investors.

 

 We are all keeping our fingers crossed and hoping for the best possible option.

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