Inflation Indexed Bond

Anuj Goyal

Introduction
I nflation-indexed bonds (also known as inflation-linked bonds or
colloquially as linkers) are bonds where the principal is indexed
to inflation.
Guarantee constant real rate of return and protects investor against
unexpected inflation.
Popular debt instrument in developed market such as USA , UK
Newzeland etc.
Issue with the aim to:
Hedging against Inflation Risk.
Enhance credibility of anti-inflationary policies.
Create an additional avenue for fund deployment and thereby
facilitating widening of Government Securities market.
Capital Indexed Bonds
Launched in 1997-6% capital indexed bond.
Only offered inflation hedging against
principal, while the coupons of the bond were
left unprotected against inflation.
Lack of credible benchmark that market would
trust.
Inflation index: WPI based
Lack of enthusiasm from investor.

How Inflation Indexed
Bonds Work
Suppose you have invested 100 rupees in inflation indexed bond. It promises to
give you 3% rate of interest annually. After one year average inflation is 5%.
Because of this 5% inflation the value of your bond will be 105 and interest
rate will be calculated in this appreciated value that is 3% of Rs 105. Now your
total worth of the bond after one year would be 105+(105*3/100=108.15. That
is 8.15% return in a year
Similarly if Inflation high as much as 12% then worth of the bond will be
112+(112*3/100)=115.36. That is 15.36% return in a year
If there is no inflation then worth of the bond will be mere Rs103 (100+3/100)
that is the promised 3% return.
It is very unlikely but if there is deflation of -5%. Then also your original value
will remain intact but Interest rate will come down accordingly. It will
95*3/100, That is 2.85%. In this case your bond will be worth of RS 102.85
(100+2.85)


Benefits of Inflation Indexed
Bonds

Capital Protection
Enhanced Interest Rate
Low Reinvestment Risk
Greatest Safety
Easier to En-cash

Negatives of Inflation Indexed
Bond

Interest Rate is low
No Tax Saving
Cant Compete with Education and
Healthcare Inflation

WPI over other Indices.
The WPI has better availability for all commodities
and for major group, subgroup and individual
commodities.
Availability at high frequency: weekly basis with a gap
of two weeks.
The coverage of non agriculture products is better in
WPI than CPI,making WPI less volatile to relative
price changes as compared to the CPI.
The coverage of tradable items, essentially
manufactured products is higher in case of WPI.

Inflation Indexed Bonds Versus Fixed
Deposit

Fixed Deposit will give fixed return irrespective
of inflation.
Suppose FD gives you 8% return and inflation
Indexed Bond has Interest rate of 3%. let us
calculate the Real Return, The return after
considering the inflation.
Inflation is 5%
Real Return from FD - {(1+.08)/1+.05)-1}
= 2.85%
Real Return From IIB 3%

Inflation rises to 12%
Real return from FD {(1+.08)/(1+.12)-1}
= -3.57%
Real Return from IIB 3%

No Inflation (For India it is a
distant dream)
Real Return from FD {(1+.08)/(1+0)-1} = 8%
Real Return from IIB 3%

Conclusion:From the above example it is evident
that Inflation Indexed bond gives constant
return irrespective of the inflation while Fixed
Deposits real return fluctuates with the
inflation

Issuance of Inflation Indexed
bonds from RBI

RBI will issue these bond on last Tuesday of every
month. In every tranche RBI will issue 1000-2000 Cr
bonds. Investor can also buy these bonds from
secondary bond market.
Other Important points
Maturity :
to begin with, IIBs will be issued for 10 years.
As it is advisable to issue IIBs at various maturity points to have benchmarks and cater to diverse
market demands, more maturity points may be explored subsequently.
Settlement cycle
Settlement cycle of IIBs will be T+1, like fixed rate conventional bonds
Frequency of coupon payment:
Like other G-Secs, coupon on IIBs would be paid on half yearly basis.
Fixed coupon rate would be paid on the adjusted principal
Issuance size
size of the each tranche would be Rs. 1,000-2,000 crore.
eligible for statutory liquidity ratio (SLR)
IIBs would be a G-Sec and issued as part of the approved Government market borrowing programme.
short-sale and repo transactions
IIBs would be a G-Sec and therefore, would be eligible for short-sale and repo transactions.




Inflation Indexed National Saving
Securities - Cumulative (IINSS-C)



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