Fixed Income
Inflation Index Bonds: Five things you must know

Inflation indexed bond is not a plain vanilla financial instrument. The real working of these bonds will be out only post 4 June 2013.  Investors need to understand these bonds thoroughly before taking a call of investments

No financial instrument has made the news in India in recent times like Inflation Indexed Bonds (IIBs). There is a lot of curiosity and excitement about these bonds. For some it looks like a panacea for all woes related to inflation, while for others it is still a Pandora’s Box. While the complete picture of these bonds will be out after the first issuance of these bonds, here are five important things that retail investors must know about these bonds before investing in these bonds:
 

A retail investor cannot quote the price/yield of his choice during issuance: Inflation index bonds will be issued through a process of auction. Retail investors will be able to buy Inflation Indexed Bond (IIB) through a process of non-competitive bidding. Non-competitive bidding means that a person would be able to participate in the auctions of dated government securities without having to quote the yield or price in the bid. As per the RBI (Reserve Bank of India) website in a non-competitive bidding, “Eligible investors cannot participate directly. They have to necessarily come through a bank or a primary dealer (PD) for auction. Each bank or PD will, on the basis of firm orders, submit a single bid for the aggregate amount of non-competitive bids on the day of the auction.”So retail investors become price takers in inflation index bond issuance process.
 

Face value of inflation indexed bond will be adjusted to inflation: In the inflation index bond face value of the issued security will be adjusted to the cash flow. The coupon will be paid on the adjusted face value; however the coupon decided at the time of issuance remains same till maturity. Effectively the coupon payment received by the investor changes but the coupon fixed at the time of issuance is not altered. Let us look at the example below of an inflation indexed bond at the time of issue:
 

  • Face Value: 100
  • Maturity: 10 years
  • Coupon: 6% per annum, payable semi-annually
     

Now assume the inflation changes by the inflation number given below in the period one. As a result of the change in inflation a new face value is arrived at which is 103 and coupon payment of 3% is made on the inflation adjusted face value which translates into 3.09%. In the 5th year, inspite of negative inflation of 8%, the face value does not fall below 100. As per the RBI circular the face value of inflation index bond will never go below par value.
 

Period

Principal

Inflation, Semiannual

CashFlow

0

100

 

 

1

103

3%

3.09

2

107.12

4%

3.21

3

109.798

2.50%

3.29

4

107.602

-2%

3.23

5

100

-8.00%

3.00

6

104.5

4.50%

3.14

7

109.725

5%

3.29

8

115.8696

5.6%

3.48

9

122.8218

6%

3.68

10

126.5064

3%

130.30

Note: This is only an example for understanding the working of IIB and not actual
working.

 

Real yield of inflation index bond may become negative:  Real yield here means that the inflation exceeds the yield offered by inflation index bonds. This has happened in both UK and US markets.  In order to buy inflation indexed bonds, the investors quote a very high price which results into a very low yield for these bonds. If the inflation exceeds quoted yield, real return becomes negative. In March 2013, the UK Treasury 2.5% 2024 index-linked bond had a current real yield to maturity (the return you get, after inflation, if you buy now and hold until the bond is paid back in 2024) of minus 1.06%. The US Treasury 0.625% 2021 bond had a real yield of minus 1%. The primary market issuance of these bonds in the US were also done at negative yield. (Refer: Treasury Sells TIPS at Negative Yields as Buyers Doubt Bernanke).

 


In India, whether this happens or not needs to be seen. However, the possibility of this cannot be ruled out. On a long-term basis this may be the case, but it can happen for a series of years or randomly till the time of maturity of bonds.
 

Price of the bond will be derived through an auction at the time of issuance: Price of inflation indexed bonds will be derived through a method of auction. This means that the price at which an investor purchases these bonds will be different from the face value. This will be a new experience for most of the retail investors as they are not used to buying security in an auction format.
 

Inflation indexed bonds will be taxable: These bonds will be taxable which means that the effective return post taxation will be less for an investor. The taxation may blunt the inflation beating capacity of these bonds. The investor will need to calculate post tax return of these bonds to see, if they have been able to beat inflation or not.
 

Inflation indexed bond is not a plain vanilla financial instrument. The real working of these bonds will be out only post 4 June 2013.  Investors need to understand these bonds thoroughly before taking a call of investments.
 

(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)

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COMMENTS

Vinay Joshi

4 years ago

Only to the uninitiated writing the above article it may be IIB’s panacea or Pandora’s Box.

June 4,2013, the said bonds will be issued, by May, 24, RBI guidelines follow.

Further PLEASE BE APPRAISED THAT FOR THE RETAIL INVESTORS THE SCHEME WILL BE ANNOUNCED BY SEPTEMBER 2013. Decipher aspects & ML introspect.

ARE YOU AWARE THAT L&T, last week issued 100CR inflation linked, capital indexed, non convertible debentures, 1.65% yield p.a,‘AAA’ CRISIL RATING!

Glaring deficiencies in your write up; TEN PONTS as under, comment if you must!

1] Comparison with overseas bond issues – just no relevance.

2] Not knowing L&T issue.

3] The bonds will not be auctioned. Not MEANT for retail at the moment. Will be sold in tranches, 1K/2kCR to mop up 12/15KCR as announced, four months indexation lag.

4] NO WORD IN THE SAID ARTICLE AS IIB’s LINKED TO WPI! [Do you know April WPI/CPI? Comment. MISSED THE POINT OF & CPI v. IIB’s FOR RETAIL NVESTORS!!

5] IRRESPECTIVE, if WPI linked, retail investors will have other options including SIP’s .

6] NO QUESTION RAISED AS TO WHY NO LINK TO CPI & WHEN? [only after CPI stabilization FYI! When can it stabilize?]

7] IN WHICH MANNER, further scheme[s] of issuances can protect savings from inflation?

8] The said IIB’s are not TAX EXEMPT but capital indexation CAN BE claimed. No mention!

9] It can be counted towards SLR requirement of banks. [many banks may switch securities in excess of 23%.] Coupon rate of 0.45% - 0.52% attractive proposition. Fifty basis points expected.

10] When & how the instrument can be priced? Now i've told you.

Expect each & every point will be answered.

Regards,





Next series of inflation index bonds could be linked to CPI, says RBI

The inflation index bonds will not enjoy any special tax benefits and all the taxes which will be applicable will be at par with any other government security. They will also be considered in the statutory liquidity ratio requirements of banks, the central bank said

The Reserve Bank of India (RBI) on Monday said the soon-to-be-launched inflation index bonds could also be linked to consumer price index (CPI) in the future.

 

“The new instruments to be issued down the line when perhaps CPI index stabilises, we may move over (to consumer price inflation). But currently, the choice is for WPI inflation for the current series which is going to be issued (on 4th June),” RBI executive director R Gandhi said.

 

Gandhi, who oversees the internal debt management department, was speaking during a specially-arranged conference call with market participants to clear doubts surrounding inflation index bonds (IIBs), the first tranche of which is to be issued on 4th June.

 

The plan came to fruition after finance minister P Chidambaram in the FY 2014 Budget announced that RBI would launch inflation indexed bonds to help public hedge themselves against price increases at a time real interest rates are still negative, thus crimping their savings.

 

IIBs are pursuant to the Budget proposal to “introduce instruments that will protect savings of poor and middle classes from inflation and incentives household sector to save in financial instruments rather than buy gold”.

 

Both the government as well as the RBI are concerned over the rising gold imports as its putting pressure on the current account deficit (CAD), which widened to historic high of 6.7% in the third quarter of 2012-13.

 

There is a strong wedge between the consumer and wholesale price-based inflation indices. Experts are of the view that linking them to the CPI will entice retail investors more.

 

He said the RBI has increased the non-competitive portion of the first tranche, which would be of retail investors' liking to 20% from the earlier 5%. One will have to contact a primary dealer and preferably have a demat account to buy these instruments.

 

The RBI is also mulling over introducing a special series of bonds for retail investors after October 2013, he said.

 

The RBI, which is targeting to issue up to Rs15,000 crore through the issuance of IIBs this fiscal, will think of additional ways of marketing the retail centric issue, Gandhi said.

 

This is the RBI’s second shot at launching inflation bonds and with gold, whose high imports are causing concern to the economy by way of record high current account deficit, being seen as a hedge against inflation due to the negative real rates of interest, a lot is being aimed to achieve from an instrument like IIBs.

 

Gandhi said IIBs are like any other government security and the money raised through the issue will be a part of the government's half yearly borrowing calendar.

 

It will not enjoy any special tax benefits and all the taxes which will be applicable will be at par with any other government security, Gandhi said, adding they will also be considered in the statutory liquidity ratio requirements of banks.

 

He further said foreign investors will be able to buy these bonds, but within the existing total investment limits of $25 billion of government debt.

 

While government bonds are issued on a weekly basis, the inflation-linked bonds will be issued separately on a monthly basis.

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RBI to launch inflation bonds for attracting household savings on 4th June

The first tranche of the IIBs-2013-14 for Rs1,000-Rs2,000 crore will be issued on 4th June, and the maturity period of these bonds will be 10 years

The Reserve Bank of India (RBI) today announced it will launch inflation-linked bonds every month, starting 4th June, to attract household savings of up to Rs15,000 crore this fiscal so as to discourage investments in gold.

“RBI, in consultation with the Government of India, has decided to launch Inflation indexed Bonds (IIBs),” the central bank said in statement.

The first tranche of the IIBs-2013-14 for Rs1,000-Rs2,000 crore will be issued on 4th June, it said, adding that the maturity period of these bonds will be 10 years. The total issue size will be Rs12,000-Rs15,000 crore in 2013-14.

After the first tranche, bonds will be issued on last Tuesday of every month.

While the first series of the bonds will be open for all class of investors, the second series issue—beginning October—will be reserved exclusively for retail investors.

RBI said the bonds are pursuant to the Budget proposal to “introduce instruments that will protect savings of poor and middle classes from inflation and incentives household sector to save in financial instruments rather than buy gold”.

Both the government as well as the RBI are concerned over the rising gold imports as its putting pressure on current account deficit (CAD), which widened to historic high of 6.7% in third quarter of 2012-13.

Gold and silver imports last month shot up 138%, year-on-year, to $7.5 billion.

Announcement of the bonds to discourage investments in gold is the second major move by RBI in the last three days. On Monday, it had placed restrictions on banks to import gold.

Giving details of the for first series of IIBs, RBI said while the coupon rate (interest rate) will remain fixed, the principal amount invested in the bonds will be linked to inflation based on Wholesale Price Index (WPI).

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COMMENTS

pravsemilo

4 years ago

To the mango man, what matters the most is the post tax return

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