Saturday, May 25, 2013

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.

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