Inflation Indexed Bonds

 

Inflation Indexed Bonds

To protect the returns on retail investors’ investments from inflation, the Government in association with the RBI introduced inflation-indexed savings certificates linked to the consumer price index (CPI) based inflation.

You see in an inflationary scenario, where prices are on a rise and have an effect of eroding the value of hard earned savings, IIBs can work well for you. But during deflationary phase, they may not yield you much luring returns since them being linked to WPI inflation. 

Well the launch of IIBs has come in at a time where WPI inflation has depicted a descending trend and moderation in the last few months. Thus one may not get attractive annual yields immediately. However if WPI inflation continues to haunt once again as the economic growth starts picking up, IIBs could yield better annual yields. 

It would be better instead of using WPI inflation for indexing, the Consumer Price Index (CPI) inflation should have been used as it is more relevant to citizens who are saddled with rising cost of living. You see, there's yet a huge gap between WPI inflation and CPI Inflation which reflects what consumers are paying. April 2013 CPI inflation at 9.39% is higher than 4.89% WPI inflation for the same month. This bonds can be used as a real hedge against inflation.

How the returns get calculated?

The final figure of the Wholesale Price Index (WPI) is taken into consideration for calculating the return of the bonds. A fixed rate on the coupon is given on the basis of adjusted principal against the inflation. This can be understood with the help of an example. Mr. Ram invested Rs 20,000 in inflation indexed bonds, at a coupon rate of 2%, now the calculation of the same is made on the basis of inflation index.

The principal adjustment is calculated as given below:

(Current Inflation Index / Inflation Index at the time of investment) * Principal invested.

Now, suppose the inflation index at the time of investment was 126, while currently it is 130, the calculation will be

(130/126) * 20000 = Rs 20,635, while the coupon rate interest will be Rs 20,635* 2% = Rs 412.7

The maturity period is 10 years, therefore, the adjusted period of maturity will be taken into account, in which the total interest due for 10 years based on the above calculations will be added to reach the final figure.

Issue Tenure and Size:

The bonds will be issued for a period of 10 years. At the initial stage, RBI has taken Rs 1,000-2,000 Crore as the size of issue in each tranche. FIIs have also been allowed to invest in inflation indexed bonds.

Some apprehensions among investors:

RBI has clarified on most of the common apprehensions of the investor of not using CPI as the mode to hedge inflation. According to the premier bank, CPI is being released from 2011 and is still in a stabilization stage. Meanwhile, monetary policy is formed on the basis of WPI inflation. Therefore, it will take some more time in coming out with Inflation bonds that take into account CPI inflation.

Taxation Check:

No special tax privilege is being provided in these bonds, which is another area of concern for the investors. Interest received and any capital gain occurring on the issue will be taxable under Income Tax Act, 1961. Another concern is that the regular interest in these bonds is lower than the FDs, because FD’s pay interest on a yearly basis, while here the interest rate is paid after adjustment at the end of tenure.

Although, taxation wise, these bonds do not lure investing class, it should be noted that a considerable period of inflation is anyways going to deteriorate the real returns. Those who are investing for a long term and have patience should go for these bonds. The core purpose of this bond option is to defeat inflation, which it is capable of handling effectively

 

 

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