Will Inflation indexed bonds be third time lucky?

By ZRG | Updated: Mar 22, 2013, 14:51 PM IST

Siddharth Tak and Rohit Joshi /Zee Research Group

P Chidambaram’s eighth budget proposed launch of Inflation Indexed Bonds (IIBs) as a hedge against rising inflation. But will these bonds be lucky third time?

The country earlier experienced such type of bonds twice without much success. The Reserve Bank of India (RBI) floated them for the first time in 1997 and the second time in 2004. This time round there is an air of expectancy though not without a fair share of skepticism.

Presenting the 2013-14 Union Budget, Chidambaram said, “In consultation with RBI, I propose to introduce instruments that will protect savings from inflation, especially the savings of the poor and middle classes. These could be Inflation Indexed Bonds or Inflation Indexed National Security Certificates.” This clearly states that these securities will provide returns in excess of inflation.

Inflation-indexed securities link their capital appreciation, or coupon payments, to inflation rates. Investors seeking safe returns with little to no risk will often hold inflation-indexed securities.

Let us understand the math behind the Inflation-indexed bonds. For instance, consider an Rs 1000 par value IIB with a 9 per cent coupon rate, set at issuance. Now suppose inflation rises to 8 per cent. In case of a simple bond you will receive Rs. 90 as an interest at the end of the year. However, in case of IIB the principal will be adjusted at Rs 1080 (1.08*1000) and the interest (coupon) rate of 9 per cent will be paid on this inflation adjusted principal value (Rs 1080). This shows that you will receive Rs 97.2 as an interest at the end of year.

Exact details of IIBs to be issued in current year are yet to be published. In 1997, when IIBs were first launched, only the principal was inflation indexed and not the coupon, while in 2004, both coupon and principal was inflation indexed to the Wholesale Price Index (WPI).

Madan Sabnavis, chief economist at CARE Ratings, said, “Conceptually, the introduction of IIB is a good idea but its success would depend on various factors like secondary bond market where there are large number of buyers and sellers. However, there is a lot of enthusiasm attached with respect to its launch owing to the fact that household savings are dipping,”But why did the bonds fail earlier? “There is a difference between a bond and deposit. An individual can break the deposit anytime but for the redemption of a bond you need a secondary market and at that time there was no depth in the bond market,” explained Sabnavis.

The timing of IIB launch is appropriate, according to Vijai Mantri, MD & CEO, Pramerica Mutual Fund. “In recent years, higher inflation has resulted in some diversion of savings from financial markets to physical assets like gold and property. As such, it is always a good time to launch inflation index bonds in a developing economy like India,” opined Mantri.

“Some people invest in gold to hedge against inflation and with the launch of IIB one can expect that some savings could be diverted from gold towards IIBs,” endorsed DK Joshi, Director and Principal Consultant, CRISIL.

But what happens in case of reducing inflation? “Although IIB works well in case the inflation is high yet the downside risk for households arises if inflation rate comes down substantially,” cautioned Sabnavis at CARE.

Most advanced countries like US and UK have well developed inflation-indexed bond market. “The participation of retail investors, however, there is still low. This (IIBs) largely are subscribed largely to by institutions,” revealed Mantri at Pramerica mutual fund. He apprehended the pattern would not be any different in India.

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