Inflation Indexed Bond

The RBI has launched inflation-indexed bonds (IIBs) to cushion your savings against rising prices. These financial instruments are meant to encourage savings and wean investors away from gold.

Why we need IIBs

Inflation erodes the purchasing power of money. Most debt products such as fixed deposits (FDs) or regular bonds provide returns that are not protected against inflation. If a bank FD pays an interest rate of 8.5% p.a.and inflation averages 9.5% that year, the investors loses money in real terms.This is where IIBs T come handy. These bonds adjust the principal investment to the inflation so that the investors earns a higher interest. For example, if a 10-year bond has a face value of 1000/- and the annual coupon rate is 10%, then investor will get 100/-. Now, if the inflation index in the next year rises by 12%, the principal will be adjusted the inflation rate and get raised to 1,120/- [1,000 * (1+12)%]. So, the next year the investor will earn 112/- as interest, which is 12% higher than the original amount. The way the returns from the investment will be safe from the incessant march of rising prices.

The calculations

The Wholesale Price Index will be used for adjusting the principal. The calculation will take the WPI index with four months' lag. For example, the final WPI for December 2012 and January 2013 will be used as reference WPI for adjusting the principal on 1 June, 2013 and 1 July, 2013 respectively. On maturity, the investor gets back the higher of the adjusted principal or the face value.

The disadvantages

Although inflation-indexed bonds prove beneficial during times of high inflation, they under-perform when the economy goes through a deflationary phase and prices actually come down. In such situation, the IIB will give lower than coupon rate because the principal would get adjusted below 1000/-. However, this is only a theoretical risk. A decline in whole-sale prices is not even a remote possibility in India.

Another drawback of these bonds is that they have been indexed to the WPI and not the Consumer Price Index (CPI). For most investors in bonds, the CPI is the more relevant index. Consumer prices matter to them in day-to-day life than wholesale prices. 

Can these Bonds beat inflation?

• Inflation -indexed bonds were first issued in the UK in 1981 and became popular in other countries as well over the past two decades.
• In the US they are referred to as TIPS (Treasury Inflation Protected Securities) and form an important part of investor portfolios.
• In India, the Capital Index Bonds 2002 were issued in December 1997. But only principal repayments at the time of redemption were indexed to inflation.
• With the launch of these bonds, more investors may not opt to save via a financial instrument instead of buying gold.
• One big drawback is that these inflation busting bonds are linked to the WPI and not the more relevant CPI.

Hoarders vs Investors

How hoarders can make a transition to investors

Enough has been written about investors' obsession with gold and real estate. Hard facts about long-term returns have been published, showing that these assets may not be a good long-term choice. However, investors view such research with skepticism. They continue to prefer physical assets to financial ones, and hold an abnormal amount as cash. Are we mere hoarders of wealth? What does it take to become investors?

First, we are guided by the nominal value of assets. What matters is the real value, after adjusting for inflation, but that is not very intuitive for most investors to perceive. When we are told no one loses money in real estate, we believe it because we have only heard of rising prices. That fact is that with a positive rate of inflation, assets prices move up over time. This is true not just for gold and property, but also for rice, dal, petrol etc. A nominal increase in price does not mean that an asset has become more valuable. As hoarders, we are happy with nominal value; as investors, we will ask about the real value, after inflation.

Second, we like assets even if they do not work for us. Assets are acquired for their ability to earn a return. This should come in the form of a regular  income, such as dividend, interest, rent, or by way of appreciation in value, which we can actually realize when needed. Assets create a sense of security and represent accumulated wealth. They are, therefore, social symbols, which tell the rest of the world that our incomes are far higher, and that we own assets acquired only by the wealthy. Ostentatious display of jewellery and lavishly decorated homes are all social symbols of wealth. When we want to belong to this class, we accumulate assets without caring for the income or the intent to realize gains. We are also reluctant hoarders, unwilling to sell these assets and strip down our social status. As rightly put by ace investor Warren Buffet - "If you buy things you don't need you'll soon sell things you need". As investors, we want the assets to work hard for us and earn returns.

Third, we obsess about the protection of invested capital. The notion is that an asset should have undiminished value dominates our choice. A physical asset, which can be seen and felt, is the obvious choice for the hoarder. Since inflation increases its price, there is a false sense of security about increasing value. The long-term return from assets that do not work cannot be different from the rate of inflation. We see the steadily rising price as hoarders, and expect this from all assets. As investors we know that what goes up will certainly come down and vice-verse. As hoarders, we fail to see the economics of asset prices.

Fourth, we do not understand the dynamics of markets. We prefer an oversimplified version of the way prices should behave since we seek a linear growth in the assets we hold. Assets prices are not influenced only by demand and supply and could also be distorted structurally. The real estate and gold markets in India are dominated by holders of black money. The unaccounted for cash invested in these assets is generated and stored outside the banking system, and is not sensitive to the changes in borrowing costs that the RBI tries to manage. Large-scale tax evasion, ill-gotten bribes and payoffs, and unaccounted for incomes hidden from the taxman feed these assets purchases.

It is a combination of these factors that turns several investors into happy hoarders. When the government says it wants to do something about this preference, it needs to work towards ensuring that the large hoarders and evaders stop distorting these markets. Before blaming the small hoarder, who is unable to make the transition to an investor, we need actual asset builders who will guide. That is the missing link