For small investors, Inflation index bonds can be beneficial. Though the real return from these bonds will be close to being a very nominal amount, the wealth erosion won’t happen

This comes in the background of increasing gold import in the country which has added to the increasing current account deficit. To wean investors away from buying gold, Reserve Bank of India (RBI) has decided to introduce inflation-indexed bonds (IIBs) in a new avatar  Whether gold import will be reduced as a result of this measure is debatable, the basic idea of these bonds is to give subscriber of these bonds protection from inflation.  It is pertinent to note that these bonds were introduced earlier in India as well but somehow could not work in terms of attracting attention of investors. In 1997, RBI has introduced capital index bonds which got matured in 2002.
 

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Inflation Indexed Bond: How it works internationally
 

What is inflation indexed bond and how it works? Many countries in the world have issued it and the idea of inflation indexed bond has worked successfully in these countries. For instance, in USA, this type of bond is called as,’ Treasury Inflation Protection Security’ or TIPS. Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of TIPS increases with inflation and it decreases with deflation, as measured by the Consumer Price Index. When TIPS matures, an investor is paid the adjusted principal or original principal, whichever is greater. In UK, such bonds are called as,’Index Linked Gilts’. Index-linked gilts differ from conventional gilts in that both the semi-annual coupon payments and the principal payment are adjusted in line with movements in the General Index of Retail Prices in the UK (also known as the RPI). Australia has issued inflation index bonds more on the pattern of USA. As per Australian Office of Financial Management,’ Treasury Indexed Bonds will be issued only as capital-indexed bonds with the capital value of the investment being adjusted by the rate of inflation. Interest will be paid quarterly, at a fixed rate, on the adjusted capital value. At maturity, investors will receive the inflation-adjusted capital value of the security - the value as adjusted for inflation over the life of the bond.
 

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Challenges before RBI
 

Issuance of inflation indexed bonds in India is full of challenges for RBI. The first and the most important challenge come from the fact that we have two indices which are used for calculation of inflation. One is Wholesale Price Index (WPI) and the second is Consumer Price Index (CPI). Which one should RBI use for benchmarking inflation indexed bonds? This is a dilemma which many governments internationally have faced. The next challenge would be identifying whether only principal should be adjusted to inflation or even coupon should be adjusted. There are both models available in the world. Adjusting both principal and coupon is a very attractive proposition for investors but very costly concept for a high inflation country like India. Additionally another aspect that needs to be considered is the taxability of these bonds. Any taxation of these bonds will reduce real returns of investors and hence these bonds should be logically tax free.
 

Benefits for Investors
 

For investors it can open a new avenue of investments. There are very few risk free investment options in India which have the potential to match inflation. As a result of this, investors have to venture into the world of uncertainties. For the small investors, this type of bond can be beneficial. Though the real return from these bonds will be close to being a very nominal amount, the wealth erosion won’t happen.