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.