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All about Inflation Indexed Bonds ( IIBs )

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Lately, depositors have seen negative returns on fixed income investments, as inflation has been high and interest rates low — while inflation has been hovering at about 10 per cent, interest rates on fixed deposits stand at an average of eight per cent, leaving investors saddled with a loss of two per cent on their investments. However, that might not be the case anymore.

Soon, the Reserve Bank of India will launch inflation- indexed bonds, a boon during times of high inflation.

These bonds would be linked to the wholesale price index ( WPI).

How it works

Inflation- indexed bonds would have a fixed real coupon rate and a nominal principal value, adjusted against inflation. Periodic coupon payments are paid on an adjusted principal. Therefore, these bonds provide inflation protection to both the principal, as well as the coupon payment.

Since the coupon would be paid on the adjusted principal, the final yield, or the cash the investor receives in hand, would fluctuate, depending on the WPI movement. On maturity, the investor would receive the adjusted principal or the face value, whichever is higher.

Assuming the principal amount is ₹ 1,000 and the coupon is fixed at eight per cent, if inflation is stable, the return would be ₹ 80. But if inflation rises five per cent, the returns would be calculated on ₹ 1,050. At an eight per cent coupon rate, it works out to ₹ 84.8. In the first tranche ( June 4), ₹ 1,000- 2,000 crore of inflation indexed bonds would be issued, of which 20 per cent would be reserved for retail investors. Based on initial issuances, the second series of these bonds for retail investors is proposed to be issued in the second half of this financial year, RBI has said.

The central bank is yet to issue details on how these bonds would operate. In a recent conference call, it had said retail investors could participate in these bonds through demat accounts, and the minimum amount for retail participation would be fixed at ₹ 10,000. There will be no special tax treatment for these bonds.

Who should invest

An advantage these bonds have is since the principal would be readjusted for inflation, the real returns on the portfolio would remain.

Retail investors should consider investing in these bonds, as these are inflation- adjusted and, therefore, commit a real rate of interest to the investor, against regular bank fixed deposits (FDs), which pay a fixed coupon on the principal. Therefore, if you had invested ₹ 1 lakh in a five- year bank FD with eight per cent interest and annual payments, your payments would be fixed at ₹ 8,000, though the real value of this would deplete, due to a rise in inflation. In fact, there is also a possibility of your money growing.

Given the safety of these bonds, it might not be a bad idea to have some amount of your fixed- income portfolio in these. But as interest rates are headed downwards, it might be better to lock into bank FDs, which are close to their peak rates. Or invest in debt mutual funds, which could give capital gains when interest rates fall. Since these bonds would be issued for 10 years, these are best suited for investors with a long- time investment horizon. Historically, in developed markets, such bonds were beneficial for investors with a long- time horizon.

These bonds would also work well for investors looking at real regular income, as interest payments are made semi- annually.

Things to watch out for

The real benefit these bonds have over FDs The fact that they are linked to the WPI means returns would not be flat, which is good. But we need to watch what the actual coupon rate would be. For instance, if the returns, that is, WPI plus coupon rate, are the same as those on other fixed- income instruments, these are not very attractive. If I have to invest in these bonds, they must offer higher returns than FDs. In their current form, another disadvantage inflation- indexed bonds have is the interest is linked to the WPI. Compared to WPI, the consumer price index ( CPI) is a better representative of the consumer's purchase power. From a retail investor's perspective, linking the interest with CPI is more beneficial. In April, WPI based inflation stood at 4.9 per cent, while CPI- based inflation stood at 9.4 per cent. Since the differential between these indices is substantial, if the interest is linked to CPI, these bonds could act as an alternative investment to gold, by offering a hedge against inflation, Liquidity is another important factor to consider. Investors should wait and see what liquidity options these bonds offer, once listed.

Retail investors can include inflation indexed bonds in their debt portfolios, as these provide a hedge against inflation. Though the coupon rate is fixed, it would be paid on the adjusted principal, which would vary, depending on inflation. This means the final yield would vary, according to inflation. Nevertheless, investors should invest in these bonds for the long term.

With RBI set to launch IIBs soon, a look at what these are and how they could benefit you

|Assuming initial investment of ~ 1 lakh; IIB principal tied to inflation |In case of IIB coupon rate of 3%, WPI is average of last seven years |Bank FD is assumed for a tenure of seven years; IIB returns are for five years

IIB at 3 % coupon Bank FD @ 8% Initial investment (~) 1,00,000 1,00,000 Increase in WPI (%) 6.59 NA Coupon rate/ interest on bank FD (%) 3 8 Interest received (~) 26,661.9 74,102 Adjusted principal on withdrawal (~) 1,56,130 NA Total amount received on withdrawal (~) 1,82,791.9 1,74,102

Yield (%) 7.83 8.24

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