As was proposed in current year Budget, RBI will release first tranche of Inflation Indexed Bonds on June 4th 2013. It is claimed that it will protect retail, especially poor and middle class investors against inflation risk. But before going ahead let us first understand how these bonds work.
Bonds are fixed return instruments where you invest lumpsum at one shot and you will receive coupon (return on your investment) either yearly, half yearly or at the end of period based on the feature of bond. After completion of period you will receive what you invested. Few terminologies which you need to understand while investing in bond market are as below.
Coupon-This is the return or you may say as interest which you receive on your investment and will be payable to you as specified in bond feature.
Coupon rate-It is the rate of return which you receive on your bond.
Par Value, Principal or Face Value-As the name suggest it is the amount which you will invest. For example Rs.1,000 face value bond means you will invest Rs.1,000. But remember that market value of bond may be higher or lower based on the valuation of bond.
Callable Bonds-Bonds which are re-purchased by issued after specified period.
Putable Bonds-Bonds which are eligible to sell to issuer after specified period.
Issuer-Issuer is the entity which that issues bonds.
Issuer Price-Price which will be available for purchase during the time of issue. Usually other than zero coupon bonds issue price will be same as that of face value. But in case of zero coupon bonds, where you will not receive any coupon during bond period, issue price will be lesser than face value or maturity value. Difference between these two prices will be your return.
Above terminologies will be for the basic understanding of usual bonds. But in case of inflation indexed bonds slight changes will be their. In Inflation Indexed Bonds (IIB) your coupon will be constant (especially in up coming RBI’s IIB bond) and variation will be in principal which will automatically get adjusted to the inflation index. To give you a clear picture, let us take one example.
Suppose you invested Rs.100 in IIB bond which is of 10 years period and coupon rate will be 5% annually. Now if next year inflation will be 6% then your principal will be raised to Rs.106 and coupon will be fixed 5% on Rs.106 but not on your invested Rs.100. So you receive Rs.5.30 but not Rs.5. That is why such bonds are also called real return bonds as your returns are adjusted to inflation.
Now let us come to the feature of Inflation Indexed Bonds which RBI is issuing.
1) Coupon rate will be fixed but as of now rate will not be available. But hope it will be lesser than normal rates.
2) Index ratio (IR) will be calculated as below.
IR=Ref. Inflation Index (on set date)/Ref Inflation Index (On issue date).
For example let us say inflation index during the period of start was 10% and inflation was raised to 12% on the set date (means date on which coupon need to be payable). Then Index ratio will be 1.2 (12%/10%). This will be multiplied by your principal Rs.100 and resulting principal for calculation of coupon will be Rs.120. Now on this Rs.120 coupon will be calculated to pay you.
Coupon I considered is 5%, Principal you invested Rs.100. Now what you receive as a coupon after one year will be is,
Rs.6=5% (coupon rate)*Rs.100 (principal)*[12%(Ref.Inflation Index on set date)/10% (Ref.Inflation Index on issue date)]
3) Reference inflation index will be Wholesale Price Index (WPI) which makes it less attractive as the real inflation which we all face is retail inflation is not possible for this bond. Also their is always a difference between Wholesale Price Index and Consumer Price Index (CPI). So you can’t say that this bond is fully inflation hedge. In wider sense if CPI was the reference then we may say that it is a real hedge against inflation.
4) Retail participation increased from 5% to 20% which I hope will make more participation. But lagging is the investor education about bond market.
5) Bond maturity period will of 10 yrs.
6) Issue date will be on June 4th 2013.
7) On maturity you will receive adjusted principal value or face value whichever is higher.
Advantages of IIB–
1) A best hedge against inflation, especially for retired and investors who looking for safer options.
2) Less volatility than normal bonds.
3) Lowest co-relation with other asset classes.
4) Diversification of your portfolio.
5) You can expect fixed long term real return which may not be possible through stock, commodity or real estate.
Disadvantages of IIBs–
1) Few expert suggest that calculation of WPI itself contains flaw. Hence believing this instrument as a real inflation hedge will be a costly affair.
2) As of now taxation is not known. So we need to think about the post tax returns too.
3) We may expect some mutual funds specifically designed for IIBs which I think will be of tax effective. But let us see how it unfold in future.
4) In case of deflation value of bond will go down and your return too. Which is not the case with other type of bonds.
5) It was actually floated to curb the Gold investment. But in my view only financial literates feel that Indian investors are investing in gold as hedge against inflation. But in reality gold investment in India is purely for ornament purpose which even god can’t stop them 🙂
6) Coupon on such bonds will be lower hence may be less attractive than other.
7) Investment process is not that much easy. I hope RBI will streamline it as soon as possible.
8) As I mentioned above reference of inflation will be WPI which makes it less attractive. Also India is the only country which have reference of WPI, but rest of all countries refer CPI as their reference index.
9) Currently inflation is easing and in such scenario investing in such bonds may not be an attractive option.
10) Until and unless Govt create awareness about bond market and liquidity issue, I hope retail investors will stay away for IIBs.