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Posted by: Uma Shashikant and Deepa Vasudevan on Fri, May 31st, 2013

Inflation Indexed Bonds (IIBs): Why 2% Coupon is a Good Idea

All fixed income assets are exposed to inflation risk. Investors know that getting back the principal of Rs.100 after 10 years is not adequate, if inflation has moved up in the interim. Even government securities - which offer government guaranteed returns - are safe only from the possibility of default. Inflation can erode the value of, and therefore returns from, the "safest" of investments. Investors should, therefore, welcome the decision of the RBI to auction its first tranche of Inflation Indexed Bonds (IIBs) on June 4, 2013.

 

A bond has two types of pay-outs- (i) Periodic interest payments and (ii) Principal redemption at maturity. Ideally, a bondholder would like both pay-outs to be protected from inflation. In reality, inflation is a changing number not amenable to exact prediction. Therefore adjustments to inflation have to be made periodically. In an inflation indexed bond, each time a pay-out is made, it is adjusted for the inflation at that point in time. (Economists know this as contemporaneous inflation).

 

If the objective is to protect the investor from an unknown change in inflation, this is best done by doing two things: (i) indicate a real rate of return and (ii) pay this real rate on an inflation-adjusted principal. RBI’s design of IIBs does this efficiently.

 

The interest rate in an IIB is typically a small percentage, say 1-2%. This is because the coupon does not compensate for inflation. It is a real rate. Consider a 10-year rate of 8%. This coupon can be divided into (1) a real rate (2) compensation for inflation and (3) uncertainty premium that is payable because investors cannot be sure about what inflation will be during the tenure of the bond. The bond gets issued at 8% if, at the time of its issue, the market is willing to accept 8% as a fair compensation for all these three factors. If investors think inflation will be around 6%, plus an uncertainty premium 1%, then the real rate is 1%. What the IIB does is primarily pay the real rate and a portion of the uncertainty premium as coupon.

 

The interesting element in the IIB is the adjustment of principal to inflation, and the indirect benefit to the investor when a fixed rate is paid on this adjusted principal. The net effect is that both principal and interest are adjusted at the same inflation rate, on a periodic basis. The efficiency in this structure is that information about inflation as it is known during the tenor of the bond is incorporated into the returns to the investor.

 

The inflation adjustment is proposed to be done by RBI using the index-ratio method to achieve this objective to a large extent. The formula and the daily index ratios placed by RBI in its website http://www.rbi.org.in/scripts/FAQView.aspx?Id=91 appear complex, but the underlying theory is quite intuitive as we shall explain in the table below:

 

We make two simplifying assumptions: (i) the IIB is issued for 5 years, and (ii) interest is paid annually. The IIB is indexed to WPI, which is assumed to be at a value of 100 (also the face value of the IIB) at the time of issue. In five years, the WPI is assumed to grow to 130.

 

Year

(1)

WPI Index

(2)

Inflation (%)

(3)

Index Ratio

(4)

Adjusted Principal

(5)

Interest @2%

(6)

 

100

 

 

100

 

1

105

 5.00%

1.050

105

2.1

2

115.5

10.00%

1.155

115.5

2.31

3

120

 3.90%

1.200

120

2.4

4

121

 0.83%

1.210

121

2.42

5

130

 7.44%

1.300

130

2.6

 

Column (2) shows the WPI index. Column (3) has the year on year inflation numbers in %: this is the number that is discussed widely when prices go up or down, investors rarely concern themselves with the underlying index values in column(2).

 

Column (4) calculates index ratio for each year as WPI for year n/WPI at issue. Here WPI at issue date obviously refers to the start of the investment period. Column (5) computes the adjusted principal. By multiplying the principal with the index ratio for each year, we are adjusting it for whatever purchasing power it has lost, starting from the date of issue. For example, at the end of year 4, the principal is shown as Rs.121; because Rs.100 had the same purchasing power in year 0 as 121 has in year 4. At redemption, the principal returned is Rs.130, which is equivalent in real terms to Rs.100 five years ago.

 

The interest pay-out is a fixed real rate, applied on this adjusted principal. For example if we were at the end of year 4, and expecting a 2% real interest, it should obviously be calculated as 2% of Rs.121; because that is the real equivalent of Rs.100 back in the issue year when the interest was promised (and the promise in an IIB is not just on the nominal coupon, but on giving a real coupon of 2%!).

 

If a bond paid a fixed rate on the face value of 100 each year, then the interest payments would not be inflation protected. If we apply the real rate on the inflation-adjusted principal we get an inflation-adjusted real rate of 2%. This is what makes the IIB an attractive proposition. There is an additional benefit from the differential tax treatment of interest pay-out and capital appreciation - that is the subject matter of another note.

Raj Kumar on Mon, Jun 3rd, 2013 11:00:33 am

Govt is worried about CAD and how to bring it down , how to move Indians away from GOLD.Secondly if the real concern is that Indians should beat Inflation in term of returns , best option was CPI and not WPI.My concern is that this WPI figures are revised(corrected) on regular basis after 1 or 2 months as others data GPD number,IIP numbers ,which data will be accepted.

Deepa Vasudevan on Mon, Jun 3rd, 2013 9:27:08 am

Hi, The returns from the IIB will depend on how interest and principal adjustments are taxed; this will be the subject matter of our next note! If the inflation factored into IIB valuation differs from actual inflation, investors may want to trade in IIBs rather than hold to maturity. These requires the market to be deep and liquid; but since IIB is a new instrument we will have to wait to assess its trading volumes.

Chetan Mehra on Sat, Jun 1st, 2013 2:17:57 pm

Hi. I did a quick calculation on XIRR the bond may generate and found it unattractive. Since the inflation adjusted principal is a bullet payment, that can be realised either on sale or on maturity. Therefore, my question is if this bond an attractive option for a HTM investor or a trader. Which leads to the point of liquidity/ trading volume of these bonds. Will an informed investor be able reduce/sell out after holding through period of high inflation. Please advise.

G VANA KRISHNA on Sat, Jun 1st, 2013 7:32:48 am

very nice and clear

C R GOPINATHAN NAIR on Sat, Jun 1st, 2013 1:12:00 am

The article gives full clarity about IIB. Thanks. Real inflation is Retail inflation / CPI. No reference to it

Sachin Sunder Poojary on Fri, May 31st, 2013 8:18:23 pm

In terms of tax benefit is concern it will not going to effect investor. 1) Current practice - Tax is charged after the indexation amount is deducted from the income. 2) As per new idea - Income received by the investor considering inflation indexation hence while tax will be applicable on the total income. Here question arise how can investor enjoy income with indexation and simultaneously gets the tax benefit?

J Jayakumar on Fri, May 31st, 2013 7:15:59 pm

Does this foregoing the coupon rate to inflation indexed principal return at maturity? Will the principal returned at maturity be subject to capital gains?

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