Investors who desire predictable real cash flows can now include indexed bonds in their portfolios. The certain real return will be attractive to investors who are particularly risk averse. It will also be attractive to savers who want to protect their savings from being eroded by inflation. More generally, inflation-indexed bonds can be useful in diversifying any portfolio of assets, as investors in other countries have already found.
Now the question arises how do they work?
Consider purchasing for Rs.100 a one-year bond that pays back your principal investment plus a nominal return of 5 percent. This bond will pay Rs.105 at the end of one year. The real value of the Rs.105 received in one year depends on what happens to prices. Suppose you expect inflation to be 3 percent over the year. While the nominal payment will be Rs.105 at the end of a year, you expect that it will cost Rs.103 then to buy what Rs.100 buys at the start of the year.
Thus, you expect to have Rs.2 of extra purchasing power at the end of the year – a 1.94 percent real increase in purchasing power. However, suppose inflation turns out to be 5 percent. In this case, the bond generates a zero real return because goods and services that could be obtained with Rs.100 at the start of the year end up costing Rs.105 at the end of the year.
The higher inflation rate eliminates your expected real return. The beneficiary is whoever issued the bond, since the issuer ends up paying a nominal amount whose purchasing power is eroded by unexpectedly high inflation.
But if inflation turns out to be unexpectedly low, your real return rises. If inflation is 1percent, your real return will be Rs.4, or 3.96percent.In general, when inflation is higher than expected, bondholders suffer unanticipated losses of purchasing power.
Conversely, when inflation turns out to be lower than expected, bond holders receive unanticipated gains of purchasing power. In such cases, those who issue nominal debt lose, since the real cost of paying off conventional nominal debt rises when inflation unexpectedly falls.
Now on the other Hand Inflation Indexed Bonds the real rate of return is known in advance, and the nominal return varies with the rate of inflation realized over the life of the bond. Hence, neither the purchaser nor the issuer faces a risk that an unanticipated increase or decrease in inflation will erode or boost the purchasing power of the bond’s payments.
Suppose you are offered a one-year bond that costs Rs.100 today and that promises a real return of 1.94 percent, which was the real return you expected in the earlier example. The bond promises that, after a year, you will be able to obtain 1.94 percent more goods and services. If inflation turns out to be 3 percent, the face value of the bond will rise to Rs.103, and the bond will pay interest equal to 1.94 percent of Rs.103, or Rs.2. But if inflation turns out to be 5 percent, the face value of the bond will rise to Rs105, and the interest payment will be Rs.2.04. In either case, you will be able to buy 1.94 percent more goods and services after a year.
For policy makers interested in inflation expectations and real interest rates, yields on the new indexed bonds can be informative. And for investors, indexed bonds offer additional investment opportunities and protection against unanticipated real losses and gains that arise with nominal debt and unexpected movements in inflation.
Government of India’s Inflation Indexed Bonds
An Ideal instrument that is RISK FREE and will also protect savings from Inflation.
Now do not let inflation erode the value of your money. Earn 1.5% percent more than the inflation rate.
The Government of India now brings you Inflation Indexed Bonds that will protect your savings from inflation and allow you to earn more interest on your savings.
Investment Amount: Minimum investment Rs.5000, Maximum investment Rs.5 lakh p.a.
Tenor of Bonds: 10 years
Rate of Interest: Base Rate of 1.5 %( annual) + Inflation Rate based on the final combined Consumer Price
Index (compounded half- yearly). For example, if inflation rate is 9.5%, then annual rate will be 11% (i.e. fixed rate 1.5%+ inflation rate of 9.5%)
Early Redemption: After 1 year for Senior Citizens and after 3 years for all others
For investment – contact nearest bank branches (even if you don’t have account there) of SBI & Associates, Nationalized Banks, HDFC Bank, ICICI Bank, Axis Bank and SHCIL
Subscription closes by 31/03/2014
For Application Form and further details, visit RBI website (http://rbi.org.in)
(Author may be contacted on firstname.lastname@example.org)