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Inflation-indexed bonds: The safest investment option

Tax and investment consultant Subhash Lakhotia simplifies the various advantages of inflation indexed bonds and how they will be helpful to small time retail investors from inflation.

June 25, 2013 / 06:50 PM IST

Subhash Lakhotia
Tax Guru: CNBC Awaaz and Tax and investment consultant

A large number of retail investors in West Bengal lost tonnes of their money in the recent Sarada chit fund scam.  Chit Fund companies are becoming cheat fund companies and the biggest sufferer are the small and medium-sized investors. 

In the past, lucrative risky investment proposals were made available in the market and the retail investors opted for such schemes. They ultimately burnt their fingers. 

Also read: Inflation-indexed bonds subscribed fully in RBI auction

Forty years ago Sancheta Investment Company in Kolkata lured the common investors of hefty return on their investments and a large number of salaried employees in particular had suffered. 

At that time many salaried employees had even withdrawn their accumulated savings from their Provident Fund Account and invested in it. Nothing could be recovered at the end of the day.

The finance ministry has appreciated the need to think of some investment proposal especially for the common investor.  While introducing the Budget for the year 2013-14, our finance minister P Chidambaram mentioned in his budget speech that he wanted to introduce instruments that will protect savings of the poor and middle class from inflation.

Further the Finance Minister continued that these instruments could be inflation-indexed bonds or inflation indexed national security certificates.  Acting on the desire of the finance minister to introduce such instruments, the Reserve Bank of India (RBI) brought out Inflation Indexed Bonds in the first week of June, 2013.  

The basic purpose of these bonds is to protect savings of poor and middle class from inflation. It also incentivises household sector to save in financial instruments rather than buy gold.  The first tranche of such bonds issued in June 2013 for Rs. 1000 crores were largely captured by large institutional investors such as pension funds, insurance and mutual funds.
In the year 1997 the RBI had issued capital indexed bonds.  Those bonds provided inflation protection only for the principal amount of investment.  However, these (inflation-indexed bonds) are expected to provide inflation protection not merely for the principal amount but for the interest also.

The small and medium retail investor will definitely stand to benefit by investing in these.  During the current financial year the RBI is likely to issue such bonds to the tune of Rs. 15,000 crores.  However, for the retail investor, new series of bonds are expected only by next quarter. 
As the investments in these bonds are going to take care of the prevailing inflation in the country, the common investor can expect a good deal on his investment on these bonds. 

With the going trend in rising prices of the real estate and gold, the common investor is not of the investment decisions to beat the rising inflation.  So, these bonds will help the common small investor to safeguard his principal amount and receive the yield of the investment based on the prevailing inflation.

The need of these bonds was appreciated by the RBI even a decade ago.  It was in 2005 the RBI came out with a discussion paper on capital indexed bonds. Currently, the focus is clear on protecting the principal and yield consequent to the prevailing inflation index from time to time. 

However, the emphasis should be on making available these bonds mainly for retail participation.  

The real purpose of these bonds would not be fulfilled if it is not made available for retail participation.  Now, the first tranche of these was mainly captured by large institutional investors.  However, the central bank has assured that the second series of these bonds will be exclusively for the retail investors. 

The terms and conditions for these should be simple.  After some time these bonds will be actively traded in the secondary market.   

In the last four decades, gold has been used as hedge against inflation.  Rightly so, the investment in gold for most investors proved that here it was a real shield to take care of the inflation.  With the present volatility in the gold prices, investment in gold may not offer any capital protection for the mounting inflation. 

Similar is also the situation with regard to investment in real estate.  Small retail investors are not able to collect sufficient funds to make investment in real estate. Due to liquidity problems, the investment in real estate at today’s prices cannot be used as hedge against inflation. 
The salient features of the first series of Inflation Indexed Bonds which were issued on 4th June 2013 is as under :-

1. 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.; At maturity, the adjusted principal or the face value, whichever is higher, will be paid.

2. Index ratio (IR) will be computed by dividing reference index for the settlement date by reference index for issue date (i.e., IR set date = Ref. Inflation Index Set Date / Ref Inflation Index Issue Date).

3. Final Wholesale Price Inflation (WPI) will be used for providing inflation protection in this product.; In case of revision in the base year for WPI series, base splicing method would be used to construct a consistent series for indexation.

4. Indexation Lag: Final WPI with four months lag will be used, i.e. Sept 2012 and Oct 2012 final WPI will be used as reference WPI for 1st Feb 2013 and 1st March 2013, respectively.; The reference WPI for dates between 1st Feb and 1st March 2013 will be computed through interpolation.

5. Issuance method: These bonds will be issued by auction method.

6. Retail Participation: Non-competitive portion will be increased from extant 5 percent to up to 20 percent of the notified amount in order to encourage participation of retail and other eligible investors.

7. Maturity: Issuance would target various points of the maturity curve in order to have benchmarks. To begin with, these bonds will be issued for tenor of 10 years.
In a press release, the RBI clarified that the second series IIBs, for retail investors, will be issued in October. The first series of bonds will help to determine the coupon rate through auction. 

The new series should have a mention of the coupon rate and other connected matters as most of the retail small investors may not be able understand the concept of coupon rate. 
It is suggested that the Government should adopt the consumer price index (CPI) instead of wholesale price index (WPI). CPI stands as a better representative of the purchasing power of the individual. 

For example, the current WPI is 4.89 percent while CPI is 9.39 percent.  The difference is quite high.  It will be realistic if the CPI is adopted to provide a positive relief.  The interest will not be paid to the investor on year-to-year basis but at during redemption.

The face value of such bonds to the principal will be adjusted with the inflation. Thus, at the time of redemption itself the adjusted principal amount or the face value of the Bonds, whichever is higher, would be paid to the investor.  The interest, however, would be paid to the investor from time to time depending on the terms. 

Generally, they are for ten years.  However, mobility will be available to the investor for pre-mature encashment as these would be listed on the stock exchange.  The Government has not thought of any specific tax exemption, deduction or rebate or extra additional tax benefit in respect of investment on them. 

The interest will be subjected to income-tax.  At the time of maturity the amount received will enjoy the benefit of cost inflation index especially when they are sold after three years. To encourage secured safe investment in these, the government should also provide for tax deduction under section 80C of the Income-tax Act, 1961. 

In case, the Government were to think of granting tax deduction on investment, then surely the investment of the common man would flow very fast in these.

It is good to see the Government appreciating the need of issuance of an instrument of investment safeguard the common man.  The Government should also think a sort of Social Security Scheme would be achieved by making these Bonds really effective, lucrative and interesting. 

For this purpose, if certain tax sops are made available to the investors of these bonds that it will go a long way in bringing very big chunk of money of small investors whereby the investment of these small investors is safe, secured and takes care of mounting inflation in the years to come. 

The more and more these bonds are made popular, the more concern will be of the Government to ensure that inflation is kept under control.

In nutshell it can be said that small retail investor in particular should wait and watch for the new investment opportunity in the next couple of months.

The Author is Tax and Investment Consultant at New Delhi for the last over 40 years.

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