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Inflation Indexed Bonds (IIB) - Latest Investment Product in town

Vikas Sonigara | 10 Jun, 2013  | Follow Author | Add to my Favourites 
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Historically we have seen investments in gold as a hedge against inflation. Traditionally, we Indians love gold and have always seen gold as an asset which is passed on from one generation to another. Gold as an investment has given spectacular returns in last 5-7 years (apart from the recent 10% slump). This huge rush for gold has lead to huge imports of gold. India is the world’s largest consumer and importer of gold. Such high imports have lead to high Current Account Deficit (CAD ~5%) which is alarming for any economy.

One of the measures RBI has taken to bring down CAD is to cut imports of gold. Hence besides raising the import duty on gold from 2% to 8%, it has also brought in an alternate investment product i.e. Inflation Indexed Bonds (IIB) which will provide hedge against inflation.

Another reason why IIBs were brought in was to increase the breadth of investments options one has which will give real returns (i.e. beat inflation).

Here is what RBI has said when introducing IIBs
“Pursuant to the announcement made in the Union Budget for 2013-14 to introduce instruments that will protect savings of poor and middle classes from inflation and incentivise household sector to save in financial instruments rather than buy gold, RBI, in consultation with Government of India, has decided to launch Inflation Indexed Bonds (IIBs)”.

What exactly are IIBs?
Typically when one invests in a bond, he/she receives a fixed coupon (interest rate) on the face value of the bond. E.g. for a 1 year bond, if the face value is Rs1,000 and the coupon is 8%, the interest accumulated after 1 year is Rs80 i.e. the person would have earned Rs80 as interest and he would get back Rs1,080 at the end of 1 year.

Now let us assume that inflation for that year was 7%. Due to this his effective earnings would reduce by inflation. Thus his effective earnings is just 1.0% i.e. 8% –7%.

Eventually what it means is inflation has ‘eaten’ into the earnings.

To give returns higher than inflation, IIBs were introduced.

Now with IIBs, the principal would be adjusted to the level of inflation and interest would be paid on the adjusted principal.

Hence in the same example if 1 year IIBs are issued with face value of Rs1,000 and coupon rate of say 1.5%, then with an inflation of 7%, the calculation works out to
New Face value = Rs1,070 (7% added on Rs1,000)

Hence interest payable will be Rs16 and the person will get back Rs1,086 (1,070+16).

Some Salient Features of IIBs
  • IIB will be using Wholesale Price Index (WPI) as the base. WPI with a four month lag will be chosen to calculate the Index ratio
  • Inflation component on principal will be adjusted by multiplying principal with index ratio (IR)
  • Interest will be paid with a fixed coupon rate on the inflation adjusted principal
  • Interest payout will be twice a year
  • These bonds will have an unique feature of Capital protection i.e. if due to deflation, the value of adjusted principal goes below face value, the redemption will happen on face  value i.e. at the time of redemption higher of the adjusted principal or face value will be paid
  • To illustrate let us assume a hypothetical 3 year IIB with face value of Rs1,000


Year

Assumed
Inflation
(WPI) - A

WPI Index

Index
Ratio

Inflation
adjusted
principal

0

 

100.0

1.00

1,000.0

1

2.0%

102.0

1.02

1,020.0

2

-2.0%

100.0

1.00

999.6

3

-3.0%

97.0

0.97

969.6


Now at the time of redemption, even though the inflation adjusted capital value is Rs970, the redemption will be for Rs1,000 i.e. face value
  • These bonds can be used for meeting repo requirements and Statutory Liquidity Ratio (SLR) of a bank
  • Foreigners are allowed to invest in these IIBs

Will they be treated differently for Income Tax?
There will be no special tax treatment for these bonds and both Interest payments and Capital gains will be taxed as per current applicable laws i.e. Interest will be taxed as per one’s current tax slab for a financial year and capital gains will be taxed at flat 10% or 20% with indexation.

Have these been issued?
Yes. RBI has sold IIBs worth Rs1,000 crore in an auction on 4th June 2013.The coupon rate was set at 1.44% for a maturity of 10 years.

Let us see what returns one can expect from this 1.44%, 2023 IIBs using some hypothetical numbers

1.44% - 10 Years Inflation Indexed Government Stock, 2023

Period

Coupon

Assumed
Inflation
(WPI)

WPI Index

Index
Ratio

Inflation
adjusted
principal

Coupon Payment

4-Jun-13

1.44%

 

170.4

1.00

1,000.0

 

4-Jun-14

1.44%

7.5%

183.2

1.08

1,075.0

15.5

4-Jun-15

1.44%

8.0%

197.8

1.16

1,161.0

16.7

4-Jun-16

1.44%

7.2%

212.1

1.24

1,244.6

17.9

4-Jun-17

1.44%

7.0%

226.9

1.33

1,331.7

19.2

4-Jun-18

1.44%

6.8%

242.3

1.42

1,422.3

20.5

4-Jun-19

1.44%

4.5%

253.2

1.49

1,486.3

21.4

4-Jun-20

1.44%

3.0%

260.8

1.53

1,530.9

22.0

4-Jun-21

1.44%

-1.0%

258.2

1.52

1,515.6

21.8

4-Jun-22

1.44%

3.5%

267.3

1.57

1,568.6

22.6

4-Jun-23

1.44%

7.0%

286.0

1.68

1,678.4

24.2

             
 

Principal Repayment

1,678.4

   
 

Average Inflation

5.31%

   
 

Rate of Return on IIB

6.90%

   


From the above example one can see that one should not expect exceptional returns from these IIBs and these returns can be very low when there is period of low inflation or even deflation.

Hence there needs to be some more incentives given to these bonds in order to attract more retail investors which was the ultimate aim behind this investment product.

 What could have been improved?
  • Linking IIBs to Consumer Price Index (CPI) instead of WPI as common man feels the heat of CPI more as compared to WPI
  • Some tax waivers can be given on these bonds for retails investors e.g. these can be included as tax saving instruments , capital gains can be tax free etc. This will encourage more retail participation

Let us wait for the next set of IIBs which RBI is planning to issue in Sept-Oct 2013 purely for retail investors to see if retail investors give a thumbs up to this product or not.

Happy Investing!

Disclaimer: The author has taken due care and caution to compile and analyze the data. The opinions expressed above are only the views of the author, and not a recommendation to buy or sell. The author does not accept any liability whatsoever arising from the use of any of the above contents



About Vikas Sonigara
The author, an alumnus of IIT Roorke, has been an active investor for the past 15 years.He blogs about financial markets and various financial products at www.finfundaz.com His articles aim to help audiences make informed and rational financial decisions.

The author can be contacted at [email protected]

Disclaimer: The author has taken due care and caution to compile and analyse the data. The opinions expressed above are only the views of the author, and not a recommendation to buy or sell. The author does not accept any liability whatsoever arising from the use of any of the above contents.



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