A New Investing Tool – Inflation Indexed Bonds

Dr. Sanjiv Agarwal

It is a known fact that Indian economy has been hit hard by continuous inflation over past few years now and inflation has been on a rise unabated. In such a situation when country is passing through an inflationary phase, the returns, incomes, yield- everything fetches you a lesser value as inflation dents the value of return. Higher inflation results in negative or lower returns on financial instruments.  For example, if you earn an interest of Rs. 100 on your investment which you get after one year, in an inflationary economy, Rs. 100 after one year may fetch less value for money in terms of purchasing power as compared to today.  Bank deposits are popular saving tool. If a bank deposit for 2 years fetch and interest of 8 percent per annum and inflation is at 9 percent, the real return is negative by one percent. Negative returns erode savings as well as earnings. This is understood time value of money. A sum of money today has more purchasing power then the purchasing power it would have after some time as the inflation will make things you want to buy costlier in future.

Since normal returns do not seem to be attractive, investors tend to move to riskier assets such as bullion or stocks or even real estate but the fluctuations and unpredictable return patterns make them a very risky investment option.

Reserve Bank of India (RBI) has recently launched inflation indexed bonds for retail investors. Such bonds are designed with the objective of protecting savings from inflationary or rising prices as the return is fixed to inflation. The real return may fall or rise based on price rise or fall in the economy. In other bonds, the return is fixed.

Inflation indexed bonds protect both, the principal as well as interest against inflation. However, in a deflationary situation, the interest received will be reduced but the principal amount of investment will remain intact as the capital would stand protected. It thus provides hedge against inflation.

In such bonds, interest will be inflation adjusted and paid half yearly and inflation will be adjusted to the amount invested in index ratio based on prevailing inflation. Retail investors can participate for investment in inflation indexed bonds. Investment in bonds shall be through subsidiary general ledger of constituents for institutional investors and through respective demat accounts for retail investors. The minimum investment is as low as Rs. 10,000 with a cap of Rs. 2 crore for individual participation. There is no limit for secondary market trades or investing in primary auctions through dealers. Banks as well as foreign investors can invest in inflation indexed bonds.

However, such bonds (first issued in June, 2013 first week) are linked to whole sale price index (WPI) and not consumer price index (CPI), which is more relevant at the retail level. For example, in April, 2013, WPI was 4.89% as against CPI at 9.39% and this gap is wide enough to deny the real benefit. One should wait and watch for more index bond issues to tap the market as presently, they also do not have any tax benefits. Both interest income and capital appreciation shall be subject to income tax. It is understood that RBI is pondering upon the idea to have CPI as base instead of WPI for inflation indexed bonds in near future. Once the CPI stabilizes which is likely, we may see more of such bond issues hitting the market.

Inflation bonds are desirable when inflation is on a rise, which has been so far in our country. Moreover, RBI may be fine tuning this product in due course. Till then, one may invest in inflation indexed bonds on a moderate basis. Bank deposits upto Rs. one lakh are considered safe from principal point of view.

Also, since inflation has just started correcting, it may be advisable to wait and invest when inflationary trend restarts. All said and done, inflation index bonds will become popular soon, once retail investors understand their hidden advantages. Also, such bonds are likely to undergo structural changes in near future to make them more popular and investor friendly.