IIBs for small investors
Real return from these bonds will be nominal, but wealth erosion won’t happen.
Inflation is eating up our savings. Each passing day prices of commodities like food products, consumer goods etc are shooting up. Every day value of money is pulled down. If you just calculate the value of a hundred rupees note, you will find a visible depreciation of the note, as it would be now fetching you far less than what you used to buy with it a year ago.
So, what’s a major concern today is to devise a strategy to shield against the onslaught of inflation and rising prices.
We have observed that investors generally use gold to hedge against inflation. They typically buy large quantities of gold when wrath of inflation is devaluing their investment. This is the reason that the demand for gold increases during inflationary times due to its inherent value and limited supply. While looking at the impact of rising demand of gold during inflation, its import is inevitable.
The economy of countries involved in the import and export of gold gets affected. In a situation where a country imports more than it exports, the value of its currency declines. A country that exports gold will see an increase in the strength of its currency when gold prices increase. On the other hand, the value of currency of a country declines when it imports gold. Precisely, countries that are large importers of gold will inevitably end up having a weaker currency when the price of gold rises.
In India we have been witnessing increasing import of gold, as small investors continue to bring more and more gold into their investment portfolio. To halt the rush of these investors towards the yellow metal, Reserve Bank of India (RBI) has decided to introduce inflation-indexed bonds (IIBs) with an aim to protect the investors from the wrath of inflation.
Let’s first understand the meaning of bond in financial terms. Wikipedia defines a bond as a debt security - an instrument of indebtedness of the bond issuer to the holders and depending on the terms of the bond, the issuer is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity.
In simpler terms, a bond is a form of loan. The investor who purchases the bond is the lender (creditor), while as who sells these bonds (issuer) is the borrower (debtor). The interest is coupon is the interest.
When a bond is issued, the price investor pays is its "face value." Once the investor buys it, the issuer promises to pay the investor back on a particular day- the "maturity date" - at a predetermined rate of interest, which is known as the "coupon."
Now, coming to the concept of inflation-indexed bonds (IIB). Since RBI is toying with the idea of launching inflation-indexed bonds (IIBs) to wean away investors from buying gold, it merits a mention to know its features. Notably, RBI had introduced these kinds of bonds some years ago but that didn't take up due to some ‘design flaws’. According to the RBI Governor D Subbarao, these inflation indexed bonds shall be re-introduced into the market in a new form.
Inflation Indexed Bonds protect money from losing value during an inflationary phase. Moreover, it is an investment opportunity by actually getting the coupon rate as interest on the money deposited. And they are risk free. Precisely we can say the IIBs in an investment portfolio lower the risk, protect it from inflation and are an income generating options.
How is inflation-indexed bond different from a regular bond? Take a regular bond, for example, for Rs. 100 with a coupon rate of 3%. Consider that the inflation rate is 5% when the bond matures. Therefore, the actual value of the bond is Rs. 105 but the coupon payment is Rs. 103. Thus, in actual terms the bond holder (investor) is at a loss of Rs. 2.
With Inflation-Indexed Bonds such problems are taken care of. This is because the bond is indexed to the inflation rate. For example, assume an IIB issued at a face value of Rs 100 with a real coupon rate of 4 per cent paid annually. If the cumulative inflation hovers at 5 per cent at the time of coupon payment, the principal calculated for the coupon payout will be Rs 105 and the coupon payment would be Rs 4.20.
If prices sink leading to deflation of 5 per cent, the indexed principal would be Rs. 95 and the real coupon payment Rs 3.80. This will be repeated every year. However, at the time of redemption, the principal repaid would be equivalent to its par value. It can't be less than Rs 100.
Notably, inflation is measured in many methods like calculating the Consumer Price Index, Wholesale Price Index etc. These IIBs are linked to either of these price indices. Here lies the challenge for the RBI. Since we have two indices - Wholesale Price Index (WPI) and Consumer Price Index (CPI) to calculate the inflation - which one should the central bank use for benchmarking inflation-indexed bonds? Then whether only principal should be adjusted to inflation or even coupon should be adjusted also poses a challenge. Experts say that adjusting both principal and coupon is a very attractive proposition for investors but very costly concept for a high inflation country like India. Besides, taxation of these bonds is also an issue which needs deliberations. Levying of tax on these bonds will have an impact of the returns of investors. So can’t these bonds be tax-free?
Lastupdate on : Mon, 4 Feb 2013 21:30:00 Makkah time
Lastupdate on : Mon, 4 Feb 2013 18:30:00 GMT
Lastupdate on : Tue, 5 Feb 2013 00:00:00 IST
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