To start with Inflation Indexed bonds, it is better to start with what bonds are actually. Bonds are fixed income securities or financial instrument by means of which an investor loans money to a particular entity in return for periodic interest payments or coupon and repayment of the amount loan at the end of the agreed maturity. The rate of interest that the investors demand is normally based on the risk profile of the borrower, inflation expectation over the maturity period and the real yield demanded. After adjusting for inflation, a real rate of return is what the investor expects out of it.
During the year 1997, Inflation Index Bonds were issued in the name of Capital Index Bonds (CIBs), but there are certain differences between the two. The CIB’s has inflation protection only to the principal but not to the interest amount, while IIBs provide protection for both – principal and interest amount.
With the issue of Inflation Index Bonds, RBI is trying to cushion an individual’s savings against rising prices. With IIB, it is possible to make savings and wean investors away from gold. The launch of these new financial instrument has definitely attracted investors at the same time, provided them with a new option to protect their savings from the grip of inflation.
The requirement of IIB’s
The purchasing power of money gets eroded with inflation. Most of the financial instruments including Fixed Deposits (FD) and regular bonds do not protect against inflation. For example, if a bank FD pays an interest rate of around 8% per annum and the inflation averages 8.5%, the investors looses money in real terms. That is exactly where IIB creeps in, these bonds adjust the principle investment to the inflation so that the investor could get back a greater return.
In addition to this, investment in the Inflation Index Bonds can also be used to stabilise the investment portfolio, as the principal rises with the portfolio. But, in case, if the inflation falls, the principal amount does not go below the principal amount.
Inflation Index Bonds can be redeemed at the amount at which they were issues initially or it could also be termed as the inflation-adjusted principal.
Risk associated with investment into regular bonds
The fixed rate of return that investors demands, is completely based on inflation expectation. With investment in the regular bonds, there is chance that the actual inflation over the maturity period is much higher than the inflation expectation of the investor.
In case if the actual inflation gets higher than what is expected by the investor, the investor ends up with negative rate of return. The risk is more in case of long-tenure bonds, with en extended maturity period of some 30 years.
Inflation index bonds claims to reduce risk for the investors
While regular bonds offer high risk factor, Inflation index bonds ensures that the investors get the real rate of return. The return, an investor gets will be a fixed premium over some measure of inflation such as the Wholesale Price Index (WPI).
That is, in very simple terms, interest payment that the investors would receive would tend to vary from year to year, depending on the rate of interest. However, the investor will be protected as he would get back the real rate of return on investment. For pension and retirement funds investment, IIBs can be a great option.
The structure, as proposed by RBI suggests that the coupon, or the rate of interest will remain fixed, the principal will be indexed to inflation. For an instance, if the investor invests in a bond of face value of Rs 100 for a 5% interest rate, in which average inflation is 5% the principal will be increased to Rs 105 after one year and the 5% return will be calculated on this higher amount.
Some disadvantages that comes hand in hand with IIBs
IIBs have loads of advantages and are treated as a great option for investment, keeping the rising inflation in mind. Inflation Index Bond, often underperform when the economy goes through a deflationary phase and the prices gets reduced. During the deflation phase, the IIB tend to give lower than the actual coupon rate because the principal would get adjusted below Rs. 1,000. Nonetheless, this could still be treated as just a theoretical risk.
IIBs are indexed to the Wholesale Price Index and not the Customer Price Index (CPI), which is supposed to be another drawback of these kinds of bonds. For most of the investors, who invests in bonds, CPI is far more relevant index. Consumer price is what matters, if we consider the day to day life and not the wholesale price.
With the IIBs coming in, chances are there for the investors to keep high on their savings. However, it has certain disadvantages, the advantages seems to attract investors more.