Inflation Indexed Bonds in India

Reserve Bank of India (RBI) which is the central bank of the country has recently started issuing inflation indexed bonds as proposed by the Finance Minister of India. Though this is not a new type of investment venue elsewhere in the world, this is the first time the Government of India introduced this class of investments in India. The first inflation indexed bonds were issued in UK in 1981 and became popular in developed markets over time. In US these are known as Treasury Inflation Protected Securities (TIPS).

Reserve Bank of India has issued the first tranche of the bonds with a 10 year maturity period during early June and the issue was oversubscribed by 4 times. These bonds were indexed to Whole Sale Price Index (WPI).

What is a Bond?

Bonds are fixed investment securities through which an investor can invest amounts in an entity be it a corporate or Government or Government entities like Municipalities etc.,  and can receive periodic interest payments (known as coupon payments) and principal on maturity. The interest payment is often on half yearly basis or annual basis. There is a whole host of instruments available under the bonds like Zero Coupon Bonds, Bonds with call option, Bonds with stepped coupon payments etc. Many banks, financial institutions, brokerages have separate desks in their treasuries with hundreds of thousands of professionals exclusively working on fixed income securities. Among these types of bonds available for investment elsewhere and now available in India is the Inflation Indexed Bond.

What is Inflation Indexed Bond?

Inflation is the rise in prices over a period of time. Each country generally defines a set of goods for calculating the price index. The set includes items of staple food of the country, products produced or consumed by the people in that particular country, fuel and any other relevant goods. The price index is calculated on a regular interval say monthly, quarterly etc. Based on the difference between the earlier level of index and current level the inflation is calculated as a percentage.

Understanding the inflation rates in a country is important for the governments and central planners / central banks for setting up and modification / fine tuning of economic policies. In an ideal situation, the interest rates in a country should be linked to the inflation levels, though in practice several other factors also play a part. The interest rate net of the inflation rate is the real interest rate which is available to the depositors / investors. For example the current interest rates for one year is 9.5% and the annualized inflation rate in the country is around 8.5%, the net interest return for the investors is 1% only.

This also follows the general economic principle that a rupee in hand is worth more in general compared to one which we are expected to received at a point of time in future. The value depends on the interest / income expected to forego the utilization of the rupee now, the expected inflation rates and any other factors like opportunity cost etc. In case the current interest rate is around 9% and expected inflation levels are around 10%, the investor ends with a negative return of 1%. That the amount he is going to receive in future is worth less in real terms than what he currently has on hand.

It is here the inflation indexed bonds or any other similar financial instruments play a role to mitigate the inflation risk. In case of these financial instruments, the instruments will be issued with a positive real interest yield based on the inflation rate prevailing in the country at that time. The interest rates are reset at a periodic interval based on the inflation levels in the country at that time.

For example, an issuer issues a bond with a face value of INR 100 for a period of 3 years with a coupon rate of 8% (indexed to inflation) and coupon is payable at half yearly intervals. Suppose the inflation rate at the time of issue of the bonds is around 6%. The price index based on which the bonds were issued is 100 and after six months it is 106. The net yield to the investor will be 2% (8%-6%). After six months, say the inflation rate in the country is estimated at 7%, coupon rate till the next reset will be adjusted upward to 9% (7%+2%) and vice versa.

Another way of issuing the bonds is that instead of adjusting the interest rate, the principle will be adjusted to the extent of inflation rate which will in turn results in adjustment of interest payments also. The calculations could be something like below

Inflation index = Price index at the time of coupon payment / Price index at the time of Issue

Coupon payment = (Inflation index X principal) X coupon rate

If we take the above example

Inflation index = 106/100 = 1.06

Coupon Payment = (1.06 X 100) X 8% = INR 8

Say at the time of second coupon payment, the price index is 107, then the above calculation looks something like below

Inflation index = 107/100 = 1.07

Coupon Payment = (1.07X100)X 8% = INR 8.56

The difference between the two variants is that in the first the principal is not adjusted for the inflation while in the second this part also is taken care. In general the second variant is more popular.

Pros and cons of Inflation Index Bonds

Inflation Index bonds benefits investors during the periods of high inflation as it protects their real interest yields. These bonds also will take care of the principle adjustment to account for the inflation rate.

On the flip side, in times of stable or reducing inflation these bonds will result in reduced payments as well as reduced principal amounts. Also the price index taken into account for indexing may be different that what affects the investors in general. Say for example, there are two types of price indexes in India viz., Wholesale Price Index (WPI) and Consumer Price Index (CPI). The composition of these two indices are different and the inflation rates arrived at also are different. Say the inflation rate arrived at through WPI route is 6%, there is a possibility that the inflation rate based on CPI will be much higher as the composition of goods in CPI is more towards consumer items like stable foods, fuel etc. In this scenario the coupon payments and principal adjustments will not be exactly beneficial to an investor more particularly a retail one.

On the whole in a country like India where the inflation rate is high and often peaking up sharply in a very short span of time and based on the rainfall and other factors, these investments could be a good option made available to the investors.

Colour Coding of Mutual Fund Schemes in India

From 1^st July 2013, as per the directive of Securities and Exchange Board of India (SEBI), the mutual funds are to be colour coded for the risk levels. Let us look at what exactly this means

An investor need to invest in various types of investment avenues based on their risk appetite and profile. The profiling of an investor can be prepared based on several factors like age, size of the family, ages of the dependents, medical / hospital requirements, future requirements like education, retirement etc. An investment advisor can help in creating such a profile and help in choosing the possible investment avenues. However, this may not be the case always in India. Most of the investors generally invest based on the word of mouth, recommendations from Friends, news paper reports and the expert advice in media. Under such circumstances, it may not be possible for the investor to know the risk level of a particular investment to match the same to his / her risk appetite and take an appropriate decision. To mitigate this factor to some extent, SEBI has directed the Mutual Funds to be colour coded based on the risk level of the fund.  This colour coding will be compulsory for new as well as existing schemes. 

The colour code has to be mentioned by the side of the name of the scheme in the application form and advertisements along with a one line explanation of the objective of the scheme, nature of the scheme, types of targeted investments and the likely investment levels. A typical one liner may look like “This product is suitable for investors who are seeking: safety of the capital and regular income; investment in money market and gilt edged securities, invests in xxx rated securities and T-Bills / Bonds; low risk” with a Blue Colur box to be displayed by the side of the scheme name. As per the guidelines, mutual funds would also have to include a disclaimer that “investors should consult their financial advisers if they are not clear about the suitability of the product”.

The risk levels and colour codes prescribed by SEBI are as follows

Blue

The blue colour coded box will indicate low risk. Instruments such as fixed maturity plans, gilt funds and income funds will carry a blue colour code as these are the safest MF instruments. These instruments are ideal for for a fixed and safe source of income.

Yellow

The yellow colour coded box will indicate medium risk. All hybrid products such as monthly income plans (MIPs), balanced funds and unit-linked insurance plans which typically invest in both equity and debt products will be given a yellow colour. These instruments are ideal for those who seek diversification between debt and equity; a possible reduction in risk without a substantial reduction in the returns.

Brown

The brown colour coded box indicates a high-risk instrument. All equity funds such as diversified funds, sectoral funds, index funds, large-cap funds and small-cap funds will carry a brown colour code as these have a significant risk component and are prone to market fluctuations. The possible returns from these type of investments could be high with an equal likelihood and higher losses.  At the same time, the brown colour serves as a warning to anyone who is risk averse.

Colour coding serves the purpose of providing a basic indication of the possible risk levels of a scheme. However this should not be taken to be a panacea and a replacement for the investment advice. There are several aspects of MF investing that cannot be communicated through colours. Due to the very nature of the available investment options it will be difficult to capture all the nuances of each scheme’s risk profile. Operational issues like Black and White printouts of downloaded forms can create a major bottle neck.

Many investors may not be in a position to distinguish between various classes of mutual funds in the same category. Take the case of Liquid Funds and Gilt Funds both are rated low risk and will be colour coded Blue. However the associated risks with these two classes of schemes are different. Also, both index funds and small-cap funds have a brown colour code; while an index fund has the least risk among equity funds and a small-cap fund carries the highest risk. Similarly, in the case of an MIP and a balanced fund, both are coloured yellow to symbolize medium risk. However, typically Monthly Income Plan has only 5-10% of its corpus in equity, while a balanced fund can invest 65% of its corpus into equity instruments. Due to the very nature of the investment options, colour coding will not be able to capture all the nuances around risk for each scheme.

All said and done, colour coding should not be completely depended on for taking a proper investment decision. The investment should be based on other major factors nature and objective of the scheme and incase of an existing scheme the track record and current investments and their performance in the scheme.  Overall, the investors are likely to benefit from this initiative of SEBI as this can reduce instances of blatant mis-selling of Mutual Fund schemes by distributors as investors will be more aware of the risks involved.