Ruby Jacob, 23 May 2013
Keeping with the FM's annual budget proposal to introduce inflation linked debt securities to curb gold demand, the RBI is ready to launch the first set of Inflation Indexed Bonds on June 4.
Crux of Inflation Indexed Bonds (IIBs)
IIBs are different from other bonds in that your actual returns will be linked to inflation. IIBs will have a fixed coupon rate (interest rate in bonds parlance) and coupon will be paid twice a year. What will vary is the principal or par value or the amount you paid for each bond. Interest will be calculated on inflation adjusted principal.
Your principal will be adjusted twice a year for inflation. The RBI has selected Wholesale Price Index (WPI) as the reference index for IIBs. Consumer Price Index (CPI), which reflects inflation for goods and services used in households, would have been the better reference inflation index. Inflation index will have a 4-month lag. This means for coupon of June, WPI of February will apply.
Linking return to real inflation rate means that if the inflation index declines, actual coupon payment can be lesser. But case should be a cause for worry, at least for a couple more decades, for the Indian economy.
Illustration of returns on Inflation Indexed Bonds
Say a 10-year IIB with coupon of 3% is issued on June 4, 2013, with the first interest payment due on January 4, 2014. WPI on June 4 is 120, and WPI on January 4 is 132. For a par amount of Rs 1 lac the inflation-adjusted principal on January 4 would be Rs 1,00,000 x 132/120 = Rs. 1,10,000.
The semiannual interest payment for the bonds would be calculated by multiplying the inflation adjusted principal amount with the applicable coupon rate (i.e. half of 3 per cent) ie, Rs 1,10,000 x 0.03/2 = Rs 1,650.
Now in the same example, if the WPI on January 4 is 115, the inflation adjusted principal on that day would be Rs. 1,00,000 x 115/120 = Rs 95,833.33 and the semiannual interest payment, accordingly, would be Rs 95833.33 x 0.03/2 = Rs 1437.5.
For subsequent coupon subsequent payments, par principal will used and not inflation adjusted principal of the previous coupon payment date. The final maturity principal will also be the inflation adjusted one.
Other features of IIBs
All other features of IIBs will be similar to that of other government securities. Presently there are no tax benefits for Inflation Indexed Bonds. Interest and capital gains will be taxable. The bonds can be traded but the point is to hold the bonds to maturity and take benefit of their inflation linked yield. RBI intends to sell these bonds once a month, ie, the last Tuesday of every month.
Tranche 1 Inflation Indexed Bonds
Only 20% of tranche I of the bonds is open for retail subscription. The first tranche auction will guide the RBI in benchmarking future coupon rate. However if you are very excited you can participate in the first issue of Inflation Indexed Bonds on June 4 through a Primary Dealer (one of the banks or other PDs). You would require a demat account.
Here are few details on tranche I of Inflation Indexed Bonds
Issue size: Rs1000- 2000 crore
Target investors- Institutional investors (80%), retail investors (20%)
Coupon rate- Not announced yet
Issue mode- Auction
The good and bad of IIBs
Both coupons and final principal repaid will be adjusted for inflation in Inflation Indexed Bonds. Capital Indexed Bonds launched in 2002 failed to take off because only principal at maturity was adjusted for inflation.
What's uncool is that WPI has been chosen for adjusting inflation instead of CPI which is almost double WPI at the moment. However RBI says as CPI cools it may link the bonds to it in the next year or so.
Similarly there is no clarity on accessibility of IIBs for retail buyers in the future. Unless they are made available through easy windows like banks and without demat account IIBs would not go down well with common retail buyers.
RBI is expected to release an FAQ on Inflation Indexed Bonds. Come back and check this space for additional details.