One of the key flaws in the design is that these bonds do not enjoy tax benefits the way some of the other debt investment products enjoy, or as tax free bonds life PPF do

The inevitable has happened. The Reserve Bank of India (RBI) has finally acknowledged that the Inflation Indexed Bond, launched with pomp and fervour last year, has been given a very cold reception by retail investors. The bond launched last year with the name Inflation Indexed National Savings Securities-Cumulative (IINSS-C) was not lapped up by investors as the regulator thought had expected. This has been admitted by none other than RBI Deputy Governor HR Khan who told reporters on Thursday that, “We had launched inflation indexed bonds that were not successful. We are coming out with the revised version”.  It is pertinent to note that RBI had increased handling commission for entities involved in distribution of these bonds from 1% to 1.5% in cases where subscription of more than Rs100 crore was achieved by the entity concerned.

But in spite of all this, things did not work out the way they should have. Why did this happen? After all, we are a country which has very high inflation and beating inflation has been one of the challenges that most investors face. Investors take many investment risks to beat inflation. So when a product was made available to them which was focused on beating inflation, why did they not accept it?

The regulator has its own answers which are neither very convincing nor the real cause for the failure of these bonds. For those who are not aware, it is important to note that in USA and many other countries these bonds are very popular and these bonds often tend to get fully subscribed when issued. Now let us look at the regulator's explanation for the poor response to these bonds. According to the regulator, the timing of the launch of the inflation indexed bonds last time was possibly wrong, and there were issues with the public's understanding of the product. Another factor that added to the unpopularity of these bonds, according to the regulator, is the coupon payout on these bonds. which is cumulative.

Timing has nothing to do with the success of this product, which has been successful in countries across the world. Also, there was no understanding issue, most of the investors realised that these bonds won’t beat inflation even though the bonds are indexed on inflation. In fact, investors were smart enough to reject these bonds.

One of the key flaws in the design of these bonds is that these bonds do not enjoy tax benefits the way some of the other debt investment products enjoy, or as tax free bonds life PPF do. For investors in the 20% and 30% tax bracket, these bonds are not too attractive, as the interest earned is subject to taxation which makes post-tax return from these bonds  unattractive, compared with some of the other investment products such as PPF or tax-free bonds.

In order to earn high post-tax return from these bonds, the investors in the 20 percent and 30 percent tax bracket would always need inflation rates to remain on the higher side, which is against the basic premise on which the RBI has been formulating its monetary policy in the recent years. Though the RBI cannot do much to make these bonds tax-free, it can definitely impress upon the government to consider making these bonds as tax-free.

Most of the debt products in India pay cumulative returns only. PPF, NSC, and bank fixed deposits all pay cumulative returns. Investors are not at all discomforted by the frequency of payment in long term debt instruments as long as return is as promised. Even making quarterly or half yearly payments to them will not achieve the objective of attracting investors.
 
Another aspect that has gone unnoticed at the RBI end is the complexity associated with buying  these bonds. RBI guidelines say that these bonds will be held in Bond Ledger Account i.e. BLA. While investors need not open any account for these bonds, isn’t it uncomfortable for the investors to again hold one more instrument in some other way. Why not use a demat account to hold these bonds.

Last but not the least, why use only branches of State Bank of India, associate banks, nationalised banks, three private sector lenders (i.e. HDFC Bank, ICICI Bank and Axis Bank) and SHCIL for distribution of these products. Handling commission offered on these bonds is very good and many distributors will agree to sell these bonds and ensure that the target is achieved.

(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.)