INFLATION INDEXED BONDS - THE BEST ALTERNATE TO GOLD & REALTY?

By Ruma Dubey

Why do people invest their surplus money in real estate and gold? Yes, it is the most lucrative, highest return option. And that is because these two – realty and gold moves with inflation. If inflation is up, the price of these two is also up and ideally, when cost comes down, rates of these two should come down too, but it does not; the correction is always minor.

And these two are the most popular because there is no other investment option which gets adjusted with inflation. Fixed deposits or bonds or PPF and other popular avenues of investment do not move with inflation and that, in an economy where costs are ahead of all returns, becomes a self-defeating option.  There is no hedge today apart from gold and realty.

Keeping this in mind, or probably because there are not much takers for Govt bonds, the RBI is getting ready to launch a new bond – inflation indexed bonds (IIBs). Starting 4th June, RBI will sell its first tranche of IIBs to raise around  Rs.1000-2000 crore every month, with inflation-linked debt of 10-year maturities. The plan of RBI is to raise around Rs.12000 to Rs.15000 crore before end of FY14. RBI will sell to the retail investors by October and issued as an alternative to the hugely popular National Savings Certificate.

IIBs aim is to insulate investors from inflation and cost savings for the Govt on account of reduction in coupon payments with lowering inflation rate, elimination of uncertainty risk premium, and containing inflationary expectations. In IIBs, the principal is indexed to the Wholesale Price Index (WPI) periodically while the coupon would be paid on this inflation-adjusted principal. The WPI, base year being 2004-05, used will be the final WPI which comes in 2 to 2.5 months after first release. Thus the WPI used to calculate the index ratio will be four months old – index ratio of May will mean WPI of Jan/Feb will be used.

How this works is something like this. Suppose you buy bonds at par, which could be Rs.1000 and assume the interest rate is at 9%. This means at the end of the year, you will get an interest of Rs.90. Now let us assume inflation rises to 8%. So this inflation index bond will adjust the principal at Rs.1080 and the interest rate of 9% will be paid on Rs.1080 and not Rs.1000. This means, when adjusted to inflation, you will Rs.97.20 and not Rs.90.

And what happens when inflation comes down? Suppose inflation falls to 7% then principal will be adjusted at Rs.1070 and you will earn Rs.96.30. And in case of deflation, of say, 5%? The principal will get reduced to Rs.950 and interest earned will come down to Rs.85.50. Well, deflation and that too in India? Seems highly impossible so one need not worry about earning less!

At the time of redemption, if the option chosen is not cumulative, then the principal repaid would be equivalent to its par value. It will never be less than Rs.1000.

Actually, we should say that RBI is ‘reintroducing’ these IIBs as it had previously, rather half-heartedly, launched IIBs. First time was way back in 1997 where only the principal was indexed and not the interest rate. This was withdrawn and a new version was once again launched in 2004 and this time, both principal as well as interest rate were indexed. The IIBs failed because there was no faith in the benchmark and there was no real depth in the bond market. But this time around, the benchmark, the way WPI is calculated and the depth in the bond market, all have improved.

RBI probably feels that this is the right time to come with these bonds as inflation has down considerably. But with rates much lower than before, albeit still higher, IIBs now makes more sense. More importantly, there is mindless investment in gold and realty at illogically high prices. Gold especially, wherein gold imports are going up and this is leading to a skewed current account deficit. The Govt has tried its best to curb gold buying but that will not help as long as there is no alternative.

IIBs make perfect sense as it is the perfect hedge against inflation. It will help investors have a more diversified asset portfolio and give them more productive assets.