Inflation Indexed Bond Demystified

Inflation Index Bonds

In the world of finance, we often come across the phrase – “don’t put all your eggs in one basket”. What this phrase means is that investors should diversify their portfolio in order to reduce the risk exposure of one single asset. The most common investments made by investors are in equity, gold, real estate, and bonds. One such type of securities is Inflation-Indexed Bond.

                

History

• ·        Capital Indexed Bonds (CIBs) was first issued in 1997, only the principal repayment was indexed to inflation.
• ·       Again issued in 2013 by Raghuram Rajan to combat the twin deficit problem of widening fiscal deficit and expanding current account deficit. The coupon rate was 1.44% over the inflation rate. These were linked to WPI
• ·         They didn’t turn out successful due to poor marketing and tax issues so the government repurchased them through reverse auction.
• ·         Previously, IIBs was linked to WPI, but currently they are linked to CPI.

Features

• ·         IIBs will provides inflation protection to both principal and the coupon. How this is done is first principal is indexed for inflation and then interest is calculated on the adjusted principal.
• ·         Individual investors can invest from INR 10,000 to INR 2 crore.
• ·         The bonds will be taxed, interest earned will be subject to marginal rate of tax.
• ·         This instrument gives investors a chance to exit their investments.
• ·         They are available for trading in the secondary market via exchanges.

Illustration

For a IIB with a face value of ₹1000, with interest payment half yearly, assuming the coupon rate to be 2.5

	At the end of 6 months	At the end of 12 months
Assumed inflation index at start of period	100	100
Assumed inflation index at end/at settlement	105	108
Index Ratio	105/100= 1.05	108/100= 1.08
Adjusted principal	1000*1.05= 1050	1000*1.08= 1080
Interest due	1050*(2.5%*6/12)	1080*(2.5%*6/12)
Interest received	13.12	13.5

Advantages 

I. For investors

·         Long term insulation from inflation

As I have mentioned multiple times above, it hedges the risk of losing value of capital to inflation over time. The investor can be assured that their money will not lose value meanwhile it will keep giving steady returns for a long period of time. These are ideal for small investors who are looking to park their savings for a long time in a safe place while also giving steady returns.

·         Risk Diversification

Investing in IIBs, like any other security, diversifies risk. Diversifying risk in other securities might be more expensive, IIBs act as a safe haven. They balance the portfolio.

II. For the issuer

·         Cost saving

The government bears considerable inflation risk in servicing its debt. Sometimes the real cost of servicing debt may vary from the period of issuance of bonds to the present time. IIBs will help it save on interest payments if such a thing happens. It would do so by eliminating the inflation risk premium that is often a part of the yield.

·         Improved fiscal policy

Since the government wouldn’t have to add inflation risk premium on assumptions, it would save the taxpayers money from being unnecessarily wasted on interest payments, that money could be utilized somewhere else like infrastructure development or public education.  

III. For Social Welfare

·         Incentives for savings

Since these bonds are considerably safe, the general public would be incentivised to park their excess funds in these bonds. While hedging from inflation and other macroeconomic risks, they will be able to gain nominal returns for their money. This would essentially act as leakages by the government.

·         Market competition

Businesses are likely to raise prices with the information. If they think the inflation is high, they will increase the prices. The buyers will also accept the prices that the sellers quote if they feel that the prices correspond to the general inflation rate .

Disadvantages

·         Incorrect estimate of the inflation expenses

Above points were based on the assumption that there is a single perfect measure of inflation. In reality there exist many inflation indexes and none of them meet ideal market conditions. Different indexes are better measures for different sectors. Moreover, there is always some measurement bias which leads me to believe that the estimate of inflation is not exact and there is always some lag. This hinders the accuracy of calculation of indexation and hence interest payments might come out inaccurate.

·         May prove costly for the issuer.

Piggybacking from the above point that there is always some measurement bias and lag, the inaccurate calculation of the interest payments might just prove to be costly for the issuer.

·         Higher indexation

As I mentioned above, there exist many inflation indices, and the wrong choice of an inflation to index the bonds may just result in higher indexation.

Why should I invest in IIBs?

• ·         They provide capital protection as opposed to other investments like gold
• ·         Volatility in prices can be avoided as IIBs are safe.
• ·         IIB is issued by the government so it is considered very safe as opposed to gold and is trusted by investors.
• ·         It also reduces the import of gold in the country.
• ·         Compared to other investments like a fixed deposit, IIBs provide inflation-indexed interest whereas FDs provide fixed interest.
• ·         Apart from interest, the principal is also repaid adjusted to the inflation rates.
• ·         Even if the economy faces deflation, the principal value would not go below the original principal paid.

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