Inflation Indexed Bonds

Praveen Asokan, MBA-IB

Abstract-The Reserve Bank of India (RBI) has been taking several measures in development

of the Government Securities (G-Sec) market in the country. Following the announcement

made in the Union Budget 2013-14, RBI has launched a new G-Sec Instrument namely

Inflation Indexed Bonds (IIBs) on June 4th

2013. IIB will protect savings of poor and middle

classes from inflation and incentivise household sector to save in financial instrument rather

than buy gold.

Introduction:

Inflation Indexed Bonds (IIBs), also known as inflation linked bonds, are bonds where

principal or coupon or both are indexed to inflation in the economy. They are thus designed

to cut the inflation risk of an investment. In other words, the return on such bonds increases

in times of inflation in the economy thus, it guarantees real return to the bond holders. These

bonds are designed to hedge investors against inflation risk of an investment. Since these

types of bonds offer investors a very high level of safety, the coupons attached to such

securities are typically lower than bonds with a higher level of risk.

Objective of IIB:

IIBs is aimed at greater objectives of reducing investors preference for gold in

inflationary times and also protecting the savings of the retail and institutional investors

through formal financial instrument. The following objectives are supposed to be fulfilled

through IIBs:

Providing investment instrument that offers hedging against inflation risk

Enhancing credibility of anti-inflationary policies of fiscal and monetary authorities

Providing an estimate of inflation expectations

Creating an additional avenue for fund development and thereby facilitating widening

of Government securities market

Weaning away domestic households from their craze for gold and encouraging them

to invest in financial instruments.

Features of IIBs in India:

The main features of IIB are given below:

IIB will have a maturity period of 10 years.

The coupon rate is fixed for entire duration of the bond.

IIBs will provide inflation protection to both principal and the coupon.

Individual investors can invest from INR 10,000 to INR 2 crore.

IIB will be part of public debt.

Banks can invest in IIBs to meet their Statutory Liquidity Ratio (SLR) requirements.

The first series of these bonds was offered to institutional investors through the

primary auction route on June 4, 2013.The involvement of institutions is necessary for

market development and price discovery.

An exclusive tranche of IIBs will be released for retail investors in November 2013.

IIBs will have a fixed real coupon rate and a nominal principal rate that is adjusted for

inflation.

The bonds will be taxed as any other fixed-income instrument; interest earned will be

subject to marginal rate of tax.

Mechanism of IIBs:

As per RBI, the reference rate of inflation will not be the index at the time of issue

rather it will be taken with a four month lag to account for final inflation rather than

provisional numbers. As index ration will be applied for adjusting principal at relevant

settlement dates. This is the level of the index four months prior to the date of issue divided

by the level of index at the time of settlement.

Drawbacks of IIBs:

The launch of IIBs is not new to the country and earlier attempts have utterly failed in

meeting their objectives. The recent introduction of IIBs also suffer from certain drawbacks

which may come in the way of their success, these drawbacks are:

Absence of deep market- Long-term demand for these bonds will depend on how deep the

market is and whether annual issuances will be a continuous affair.

Not many maturity points- As of now, IIBs will have tenor of 10 years only and therefore it

does not provide alternative maturity points .In such scenario it may not be able to meet

diverse market demands.

No Tax Concession- There will not be any tax concessions for investing in these bonds.

Presumably, tax will be deducted at source on these investments. This could be a major

shortcoming.

Unlikely reductions in Gold imports- According to estimates, 2/3rd of gold imports go into

making of jewellery products. Therefore it is not possible that introduction of sovereign bond

would lead to reduction in gold imports.

Conclusion:

The launch of IIBs is timely and appropriate from RBIs point of view as inflation has

moderated in the economy. The product will definitely help in diversification of products in

G-Sec market. However RBI has a much broader objective of diverting investors from

investing in gold and thus reducing gold imports. However is is very unlikely that this

objective will be met with launch of a debt instrument which has a very limited investor base,

lack of maturity options and no tax exemptions.

References:

1. www.rbi.org.in

2. Economic Survey of India, 2013-14

3. Press Release of RBI dated May 15 and June 4, 2013

4. Union Budget, 2013-14

5. www.livemint.com

6. The Indian Banker, Volume VIII No.7, July 2013