Inflation indexed bonds, not the panacea

C.R.L. Narasimhan

Fulfilling a key budget promise, the government is about to launch the first series of inflation-indexed bonds (IIBs). It is clear that the government’s expectations from the bonds are large. Though not the first issue of debt instruments with variable interest rates, the bonds present a reasonably good option to investors seeking regular return, and also reasonable protection from inflation.

The government has a much larger objective this time in launching the bonds. It expects the bonds to wean the retail investors away from their preference for gold.

The insatiable demand for gold has driven up imports and contributed to a serious macro-economic problem in the form of an unsustainable current account deficit. The hope is that these bonds will become popular with those investors who fancy gold as well as real estate and other non-financial avenues.

Financial instruments

The existing financial instruments — bank deposits, mutual funds and other capital market instruments — have not been attractive enough to a large number of investors.

Gold, especially, has scored over other investment avenues for many reasons: it has consistently beaten inflation, gives capital gains, requires no documentation, no TDS or capital gains and, most importantly, confers anonymity.

The government’s earlier attempts at introducing inflation-linked bonds in 1997 and 2004 did not catch investors’ fancy mainly because only the principal was indexed to inflation. This time, however, the bonds will be structured in a way that they protect investors more comprehensively. Both the principal and interest will be hedged to a large extent from the vagaries of inflation. For now, the benchmark will be the wholesale price index (WPI),which is a serious weakness. In recent months, the WPI has been way below the consumer price index (CPI), and, hence, from the investors’ point of view understates inflation.

The government, however, is considering the CPI index as a possible benchmark.

Salient features

What are the other salient features of the inflation indexed bonds?

According to the government’s press release, 

(1) the IIBs will have a fixed real coupon rate and a nominal principal value that is adjusted for inflation. Periodic coupon payments are paid on adjusted principal.

By way of illustration, let’s say that the bonds are issued at a face value of Rs.1,000 and a coupon of 5 per cent. If the indexed-inflation rate is 5 per cent, the interest will be calculated on Rs.1050 for that year. If inflation climbs to 10 per cent, the 5 per cent coupon pay-out will be on an adjusted principal of Rs.1155. Thus, it is claimed, the IIBs will give protection to both principal and interest.

(2) On maturity, the adjusted principal or the face value, whichever is higher, is paid to the investors.

(3) The first series of these bonds will be called Capital Indexed Bonds (CIBs), and will be offered primarily to institutional investors. Subsequent tranches will target retail investors to a much larger extent. The involvement of institutions is necessary for market development and price discovery. The IIBs will be part of public debt. Banks can invest in them to meet their statutory liquidity ratio (SLR) requirements.

(4) Individual investors can invest from Rs.10,000 to Rs.2 crore. Interest will be paid half-yearly. There are no tax concessions for investing in these bonds. Presumably, tax will be deducted at source on these investments. This could be a major shortcoming.

The new bonds are certainly welcome. They give investors in debt instruments an opportunity to hedge against inflation. They can be the first step in a much-needed exercise to boost innovation in the variable return space. The IIBs will have a ten-year tenure, and funds mobilised can be deployed in infrastructure areas. Pension funds and insurance companies should patronise these bonds.

Yet, the expectations are large. It is extremely doubtful whether the IIBs can divert money going into gold jewellery. According to reliable estimates, two-thirds of the gold imports go into the making of jewels, with only a portion of the balance getting invested in gold-backed instruments.

It is unlikely that those who buy jewellery would shift to these variable interest bonds.

For these and other reasons, it is best to tone down the expectation from these bonds and view them as they are, a welcome addition to the debt market instruments.