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Inflation Indexed Bonds is a welcome option for long-term conservative saver. Find out how the early redemption penalty compares with premature withdrawal penalty of bank FDs. Should you dump bank FD and go for these bonds? Can you use it for retirement planning?
Inflation Indexed National Savings Securities-Cumulative (IINSS-C) securities are being launched by the Reserve Bank of India (RBI) in the backdrop of announcement made in the Union Budget 2013-14 to introduce instruments that will protect savings from inflation. Interest rate on these securities would be linked to final combined Consumer Price Index [CPI (Base: 2010=100)]. Interest rate would comprise two parts - fixed rate (1.5%) and inflation rate based on CPI and the same will be compounded in the principal on half-yearly basis and paid only at the time of maturity. E.g. CPI of 11.24% in November 2013 means you can expect to get 12.74% pa assuming the inflation stays at same level. The minimum and maximum investment per annum is Rs5,000 and Rs5 lakh respectively. The tenor is fixed at 10 years.
Early redemptions of IINSS-C will be allowed after one year from the date of issue for senior citizens (i.e. above 65 years of age) and three years for all others, subject to penalty charges at the rate of 50% of the last coupon payable for early redemption. Early redemptions, however, will be made only on coupon dates.
Hefty penalty for early redemption is a major deterrent, but bank FD too usually has premature withdrawal penalty of 1% lesser interest rate than the rate offered for the period FD was kept. The calculation of bank FD penalty will be similar to IINSS-C penalty and hence long-term saver in lower tax bracket should not overlook IINSS-C. IINSS-C is suitable for those saving for retirement with no need for regular interest payment from the product.
For example, if you redeem IINSS-C at the end of fourth year, you lose half the interest of the third year. For simplicity, assume 10% pa simple interest paid by IINSS-C on investment of Rs5 lakh. The interest payment is Rs50,000 pa, which means Rs2 lakh at end of four years. With 50% of last coupon as penalty, it will be Rs25,000 and hence you will effectively get Rs1.75 lakh interest after four years.
In case of 10 year bank FD @10% pa (simple interest assumed), you will have accrued Rs2 lakh after four years. Due to premature withdrawal, there will be penalty of 1% lesser interest rate than the rate offered for the period FD was kept. Assuming the interest rate for four years was same (10% pa), the interest calculation for four years @9% pa will be Rs1.80 lakh. It means the penalty was Rs20,000.
In the above example, FD fared marginally better than IINSS-C after four years. If you prolong the early redemption, IINSS-C will start looking better than bank FD as the penalty of bank FD will be onerous when you get closer to the maturity date. If the early redemption of IINSS-C was after eight years, the accrued interest would have been Rs4 lakh. With penalty of Rs25,000, you will effectively get Rs3.75 lakh interest after four years. Breaking bank FD after eight years would mean interest payment of Rs3.60 lakh (@9% pa). IINSS-C will pay more than bank FD.
Moreover, in reality the interest of IINSS-C can be substantially higher than FD during the time of high inflation. Conversely, the returns can go lower than FD in case of low inflation. FD rates can also go low when inflation dips and hence IINSS-C should be preferred over FD as long as you have commitment to stay long-term with the product. With inflation levels going up and down, the returns from IINSS-C will be in zigzag pattern. Scheduled commercial banks offer approximately 9% pa for 10-year FD, which is guaranteed and smooth for the full period.