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.
