May 17, 2013 09:26 AM IST | Source:

Why inflation bonds are best thing FM ever did for savers

IIBs are indexed to the Wholesale Price Index (WPI) which is geared to capture broader systemic inflation rather than the inflation that bites you and me.

Why inflation bonds are best thing FM ever did for savers

R Jagannathan

Fear of rising gold imports has pushed the government and the Reserve Bank of India (RBI) to announce an issue of inflation-indexed bonds (IIBs) for launch on 4 June. It’s a good move, though one has to wait and see if it is going to be a substitute for gold or something complementary to it.

The short answer to the question whether you should invest in the IIB is yes. Despite its flaws.

IIBs should be a part of an investor’s portfolio, even though it is too early to pass judgment on how well it is structured. We also need to know the actual interest rate yield offered – which the market will decide, since IIBs will have to be bid for.

In fact, one should list the obvious flaw rightaway: IIBs are indexed to the Wholesale Price Index (WPI) which is geared to capture broader systemic inflation rather than the inflation that bites you and me. The Consumer Price Index (CPI) would have been the right benchmark from a retail investor’s point of view. However, since the first issue of IIBs next month will surely not be the last, one presumes later versions of these bonds could be indexed to the CPI.

The main features of the IIBs to be issued next month are the following (read the RBI’s full note here; for a nuanced explanation, read here):

One, the principal will be indexed to a WPI base four months before. The coupon rate will be fixed, but yields will depend on bidding at auctions. But since the coupon will be paid on the WPI-indexed principal, actual payments could be higher or lower than expected nominal returns, depending on WPI movements.

Two, to enable easy liquidity, the 10-year IIBs will be listed on the markets. But given the WPI’s current trajectory, bond prices carry risks on the downside if the war on inflation actually succeeds. But that is to be seen.

Three, the first IIB issue is focused on institutional investors in order to create a market. But there is a reservation of 20 percent of the Rs 1,000-2,000 crore issue for retail investors.

Four, at maturity, the IIBs will pay the indexed value or the original principal, whichever is higher. In even a mild inflationary situation, most investors can expect to receive a higher principal back than what they invested. The only situation in which you will get only the principal back is if, in June 2024, the WPI is lower than it is early 2013. That, knowing how irresponsible our politicians are, is no real danger at all.

Five, the WPI base on which indexation will happen is the final index number (and not the provisional WPI). Thus the June 2013 IIB will be based on the January 2013 final WPI.

Six, for 2013-14, the RBI plans to raise Rs 12,000-15,000 crore through monthly auctions – maturity tenures may be varied in different tranches.

Seven, since the bonds will be sold by auction, one cannot expect them to come at face value for investors. Bidders will make their calls based on the expected trajectory of inflation, and current prices of comparable government securities. The first issue, to be of 10 years maturity, will thus be compared with the 10-year GOI bond, which currently yields around 7.4-7.5 percent.

Eight, since both the principal (and effectively the coupons) will be indexed, the latest IIBs are less flawed compared to the previous issues. If you’ve invested Rs 100, and the WPI if 5 percent up, your invested capital will be Rs 105 on which the coupon will be calculated. As the RBI says, “IIBs will be having a fixed real coupon rate and a nominal principal value that is adjusted against inflation. Periodic coupon payments are paid on adjusted principal. Thus these bonds provide inflation protection to both principal and coupon payment.”

Nine, retail investors need not rush to buy the first lot of IIBs since we don’t know how the markets will respond to them. However, there is no harm in taking them up either. Those who buy now may benefit if the initial pricing is enticing. Those who buy later will know how the market is viewing it, and can also wait for bonds with shorter or longer maturities.

Ten, IIBs are not substitutes for gold – not as yet. While both gold and IIBs are inflation hedges, gold has value also has jewellery while IIBs are only partially inflation-proofed pieces of paper. One should have both in the portfolio.

Warts and all, IIBs are the best thing P Chidambaram has ever done for savers. So go for it – now or later. You are unlikely to regret it. But watch for an update just before the launch. We will tell you if there is a thorn embedded in the fine print.

The writer is editor-in-chief, digital and publishing, Network18 Group.

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