Staying afloat on inflation-indexed bonds

The Reserve Bank of India has announced the launch of inflation-linked bonds starting June 4.

Written by George Mathew | Mumbai | Published:May 20, 2013 12:08 am

The Reserve Bank of India has announced the launch of inflation-linked bonds starting June 4. Here is a lowdown on the latest investment instrument

For investors who run after gold to hedge their investments against the menace of runaway inflation,a good investment avenue has opened up. After a long wait,the Reserve Bank of India has finally come out with inflation-indexed bonds (IIBs) — a popular instrument in developed markets like the US and the UK — that will safeguard the capital and returns of investors in an era of high inflation.

What are inflation-indexed bonds?

It’s a bond that guarantees a real return,or a return higher than the rate of inflation. Such bonds are indexed to inflation rate,or in simple words,they’re bonds with their capital appreciation and coupon payments linked to inflation rates.

Normally,countries launch such bonds to safeguard the capital of investors at a time when inflation is ruling the roost. Investors who seek safe returns,which is above the inflation level,can go for such bonds. Another aim of the Reserve Bank of India and the government is to incentivise household sector to save in financial instruments rather than buy gold,which is now the favourite hedge of Indian consumers against inflation.

IIBs also enhance credibility of anti-inflationary policies,provide an estimate of inflation expectations and create an additional avenue for fund deployment and thereby facilitating widening of government securities market.

What will be the size and maturity?

The RBI,in consultation with the government,last week announced a scheme to launch bonds from June 4,2013. The IIB issue 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. Each tranche of IIBs will be for Rs 1,000 – Rs 2,000 crore and total issue would be for about Rs 12,000 – Rs 15,000 crore in 2013-14.

Can retail investors apply for these bonds?

Retail investors will have to wait for six months. The first such tranche would be issued to institutional investors regularly through auctions on the last Tuesday of each subsequent month during 2013-14.

Second series of bonds,exclusively for retail investors,will be issued in second half of the financial year. First series of the IIBs will help in determining the coupon rate for the bonds through auction. This will help in benchmarking IIBs. Based on the experience in the initial issuances,second series of IIBs for the retail investors is proposed to be issued around October.

The RBI thinks it’s necessary to issue comparable instruments through auctions to the institutional investors initially. This will create demand for IIBs and help in making them tradable in the secondary market.

What will be the return?

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.

How is the interest payment

calculated?

The RBI will first calculate the index ratio (IR) by dividing reference wholesale price index (WPI) for the settlement date by reference WPI for issue date. Final WPI with four months lag will be used,i.e. September 2012 and October 2012 final WPI will be used as reference WPI for February 1,2013 and March 1,2013,respectively. Though the coupon rate of the bond is constant,the actual coupon payments vary as the principal of the bond is indexed to inflation. For example:

* Suppose a 10-year IIB with coupon of 3 per cent was issued on May 15,2013,with the first interest payment due on November 15,2013.·

* The reference WPI on May 15 (issue date) was 120,and the reference WPI on November 15,2004 (settlement date) is 132.

* For a par amount of Rs 1 lakh,the inflation-adjusted principal on November 15 would be Rs 1.10 lakh (Rs 1 lakh × 132/120).

* 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). This means an interest payment of Rs 1,650 (Rs 1.10 lakh × 0.03/2).

Is the timing of the IIB launch proper?

The latest IIB scheme was on the RBI drawing board for quite some time. Finally,when it is due for launch,inflation rate has started coming down in India. The latest data shows that WPI inflation fell 4.89 per cent in April as against 5.96 in March,which is very much in the comfort zone of the RBI. This means investor appetite may wane if inflation falls further as bank fixed deposit rates are still high. But,as the saying goes,“it’s better late than never.” There’s no guarantee that inflation won’t rise again in the future.

WPI or CPI inflation: What should be the benchmark?

The gap between the wholesale price index and consumer price index inflation has widened. In India,what matters is the CPI which is still around 9.39 per cent. Critics argue that linking inflation-indexed bonds to WPI may not be the best idea. By calculating the return based on prices at the wholesale level,consumers/investors still end up losing money,they say.

Many countries use CPI to calculate the returns. With a higher CPI here,it will be a costly exercise for the RBI. Besides,there’s apprehension that retail investors who are not active in government securities market will not be enthused by IIBs.

What was the RBI’s previous experience in inflation bonds?

The RBI launched an IIB styled as Capital Indexed Bonds (CIB) in December 1997. However,there was no further issuance of CIB mainly due to lack of an enthusiastic response of market participants.

Reasons: CIB only offered inflation hedging for the principal,while the coupons of the bond were left unprotected against inflation and complexities involved in pricing of the instrument. The latest inflation-indexed bond scheme has addressed these concerns to a great extent.

george.mathew@expressindia.com

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