As an investor, it must be suggested to you to diversify your portfolio across various asset classes such as equity, gold, bonds, etc. Although most of you must be aware of the terms, for the newcomers, let’s recap the term.

Bonds can be related to loans made to a company, whereas stocks offer an ownership stake in the company to the investor. The investor is usually refused the original principal at the time of maturity. Interest is paid annually unless there is something stated otherwise.

What is the meaning of Inflation-Indexed Bonds?

IIB or Inflation-Indexed Bond is a bond that is issued by the Sovereign, providing the investor with a constant return ignoring the level of inflation. It was first introduced by RBI with the motive to discourage investors from physical gold. The main aim of this bond is to protect against inflation and the security of capital.

Earlier, the interest that was earned on the bank deposits was negative taking into account the increasing inflation rate. But with the return of these inflation-indexed bonds linked to the wholesome price index, the investors can now be assured that the returns at the time of maturity will beat inflation.

How do the Inflation-Indexed Bonds operate?

To understand the concept of Inflation-Indexed Bonds, it is necessary to compare it with the instrument of fixed deposits with the bank. On one hand, the fixed deposits offer a fixed rate of interest on the investment over the given number of years, it does not protect the investors from the decreasing real value of the initial deposit because of inflation.

Inflation-Indexed Bonds on another hand, give a constant minimal real return that is not affected by the inflation level in the economy. As capital and inflation are directly proportional, capital increases with inflation. As a result of this, the actual interest is better than what was initially promised. When deflation happens, the interest payments also fall. However, the positive point here is that the capital does not decline below the initial investment or the face value in the case of deflation.

To make it easy, the working of Inflation-Indexed Bonds is given through the following example:

Case 1: End of 1st year Case 2: End of 2nd year
 

Principal Amount= Rs. 1000

Inflation in the economy= 3%

Promised rate of return= 3%

Inflation accrual= Rs. 30

Principal amount at the end of the 1st year= Rs. 1030

Interest= 1030*3/100= Rs. 31

Total Return= Rs.30 (inflation) + Rs.31 (interest)= Rs.61

 

 

Principal Amount= Rs. 1030

Inflation in the economy= 6%

Promised rate of return= 3%

Inflation accrual= Rs. 61.8

Principal amount at the end of the 2nd year= Rs. 1091.8

Interest= 1091.8*3/100= Rs. 32.7

Total Return= Rs.61.8 (inflation) + Rs.32.7 (interest)= Rs. 94.5

 

From the example mentioned above, it is deduced that the inflation component on the principal is usually not paid with interest but the same is also adjusted in the principal. When the maturity period is reached, the face value or the adjusted principal, whichever is higher would be then paid. In case the adjusted principal goes below the face value because of deflation, the face value would then be paid at redemption and as a result, the capital will be protected. Protection will be provided to the interest rates against inflation by paying fixed coupon rates on the principal adjusted against inflation.

Inflation-Indexed Bonds are treated as government securities (G-Sec) and hence they are eligible for repo transactions and short sales. They in turn also get an SLR status and are eligible to be kept a part of the Statutory Liquidity Ratio requirements of the bank. Also, there are no special tax concessions for these bonds.

Background of the Inflation-Indexed Bonds

In India, inflation was one of the major macroeconomic concerns of the economy during 2008-2013 when the real interest rates were negative. This period was also noted for the high current account deficit (CAD) and also saw a huge investment in alternative instruments such as gold, leading to its heavy importing. To reduce the CAD and attractiveness of gold, the government of India then launched the Inflation-Indexed Bonds (IIB) on 4th June 2013.

As in 2013, WPI (Wholesale Price Index) was used as a key measure to calculate inflation. The Reserve Bank of India then auctioned its first tranche linking to WPI. Inflation-Indexed Bonds were then issued monthly till December 2013, i.e. on the last Tuesday of each month. These IIB offer an annual return of 1.44% over and above the headline inflation. They can be traded in the Order Matching Negotiated Dealing Systems (NDS-OM), over-the-counter market, and the stock exchanges. In 2013, approximately IIB bonds of Rs. 6500 crore were issued.

Over time, with the significant moderation in inflation since 2014-15, the IIB bonds lost their attractiveness. These bonds turned highly illiquid, the reason being the WPI inflation remained negative for the 15 consecutive months. To improve the liquidity the government then decided to buy back the IIB bonds. The government then repurchased the 1.44% inflation government stocks in February 2016 by the method of the reverse auction for the face value of Rs. 6500 crore. This was undertaken as an Adhoc measure to help redeem the government stocks prematurely by utilizing the surplus cash balance.

RBI has now adopted the consumer price index (CPI combined) since April 2014, as the key measure to calculate inflation for its monetary policy stance. If RBI issues new IIB bonds in the near future then it will be based on CPI.

Conclusion

How much an investor should invest in these Inflation-Indexed Bonds depends upon his expectations about inflation. According to the market experts, these IIB bonds are structured in a way to be ideal for all investors and institutions. The basic purpose of these bonds is to protect investors from inflation by giving regular and fixed coupon payments.

The main aim of the government with the IIB bonds is to target people who invest in gold and to protect their portfolios from inflation. It was difficult to replace the demand for gold as the investors in India usually accumulate gold for consumption and this cannot be substituted.