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Inflation Indexed Bonds- Retail investors eagerly demands

Inflation indexed bonds is introduced by RBI with an objective to reduce the appetite for gold. It will be linked to WPI index to reduce the impact of inflation. Financial expert Jitendra Solanki gives us insightful information on how Inflation Indexed Bonds will work and benefits attached to it.

May 20, 2013 / 03:59 PM IST

In Budget 2013, inflation indexed bonds for retail investors were announced with an objective to reduce the appetite for gold. These bonds are supposed to be the perfect fit for investors who want security of capital and a hedge against inflation. The first series of these bonds are slated to be out on June 4, 2013 and so it’s important that investors have an understanding on what benefit these bonds will provide.

What is an Inflation Indexed Bond?

Inflation linked bonds are bonds that provide protection against inflation. In such type of bonds, the principal is linked to the inflation rate so that the impact of inflation can be reduced. As the inflation rate increases the principal too is changed along with it. The interest which these bonds offer is then applied to the changed principal causing the rise in interest payment too. On maturity the holder of these bonds is paid the inflated amount giving a full protection from the inflation which they are vying for.

How it will work in India?

RBI has finally announced the first series of bonds which will be issued on June 4, 2013.  These bonds will carry a term of 10 years with a fixed coupon and the principal will be linked to Wholesale Price Inflation. The coupon payment will then be paid on the adjusted principal. On Maturity the higher of adjusted principal or face value will be paid to the bondholder.

To understand more suppose a bond is issued with principal value of Rs 100 and carries a 7% coupon interest. If inflation is 8 % then the bondholder is paid interest on adjusted principal of Rs 108 i.e. Rs 7.5. Similarly the future interest payment will be based on the adjustment of the principal. At times the adjusted principal can be lower than face value if inflation falls. But since on maturity at least the face value is paid, it aims to give the desired protection to the investors.

Points to Ponder

The first series of bonds is not for retail investors. To set the benchmark for future coupon rate, RBI will be auctioning these bonds to institutional investors. So retail investors will have to wait till the next series of bonds is announced, which may happen in October.

One of the arguments which is going against these bonds is the consideration of WPI and that too with a four month lag i.e. for Mar 13 the inflation rate of October 2012 will be considered. However, CPI or Consumer Price Index has been the   true representation of consumer inflation data and with lesser errors. So for retail investors linking to CPI would have been more beneficial.

The actual coupon is also not yet announced and there will be eagerness to know what will be the course of the interest rate on these bonds. A lower coupon rate may deter demand from investors as it is fixed and not linked to inflation. This was also one of the main reason why Capital Indexed Bonds issued in the past did not generated much of interest.

With all above arguments for debate, there is always a gap in our country for such fixed income instruments which can hedge investors’ money against inflation. The demand for gold may not take a downward trend in current times as the returns are difficult to match but the demand for such debt instruments will always remain high from all categories of investors.

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