Inflation Indexed Bonds

Praveen Asokan, MBA-IB

Abstract-The Reserve Bank of India (RBI) has been taking several measures in development
of the Government Securities (G-Sec) market in the country. Following the announcement
made in the Union Budget 2013-14, RBI has launched a new G-Sec Instrument namely
Inflation Indexed Bonds (IIBs) on June 4th 2013. IIB will protect savings of poor and middle
classes from inflation and incentivise household sector to save in financial instrument rather
than buy gold.

Introduction:
Inflation Indexed Bonds (IIBs), also known as inflation linked bonds, are bonds where
principal or coupon or both are indexed to inflation in the economy. They are thus designed
to cut the inflation risk of an investment. In other words, the return on such bonds increases
in times of inflation in the economy thus, it guarantees real return to the bond holders. These
bonds are designed to hedge investors against inflation risk of an investment. Since these
types of bonds offer investors a very high level of safety, the coupons attached to such
securities are typically lower than bonds with a higher level of risk.

Objective of IIB:
IIBs is aimed at greater objectives of reducing investors preference for gold in
inflationary times and also protecting the savings of the retail and institutional investors
through formal financial instrument. The following objectives are supposed to be fulfilled
through IIBs:

Providing investment instrument that offers hedging against inflation risk

Enhancing credibility of anti-inflationary policies of fiscal and monetary authorities
Providing an estimate of inflation expectations
Creating an additional avenue for fund development and thereby facilitating widening
of Government securities market
Weaning away domestic households from their craze for gold and encouraging them
to invest in financial instruments.

Features of IIBs in India:

The main features of IIB are given below:

IIB will have a maturity period of 10 years.

The coupon rate is fixed for entire duration of the bond.

IIBs will provide inflation protection to both principal and the coupon.
Individual investors can invest from INR 10,000 to INR 2 crore.
IIB will be part of public debt.
Banks can invest in IIBs to meet their Statutory Liquidity Ratio (SLR) requirements.
The first series of these bonds was offered to institutional investors through the
primary auction route on June 4, 2013.The involvement of institutions is necessary for
market development and price discovery.
An exclusive tranche of IIBs will be released for retail investors in November 2013.
IIBs will have a fixed real coupon rate and a nominal principal rate that is adjusted for
inflation.
The bonds will be taxed as any other fixed-income instrument; interest earned will be
subject to marginal rate of tax.

Mechanism of IIBs:
As per RBI, the reference rate of inflation will not be the index at the time of issue
rather it will be taken with a four month lag to account for final inflation rather than
provisional numbers. As index ration will be applied for adjusting principal at relevant
settlement dates. This is the level of the index four months prior to the date of issue divided
by the level of index at the time of settlement.

Drawbacks of IIBs:
The launch of IIBs is not new to the country and earlier attempts have utterly failed in
meeting their objectives. The recent introduction of IIBs also suffer from certain drawbacks
which may come in the way of their success, these drawbacks are:
Absence of deep market- Long-term demand for these bonds will depend on how deep the
market is and whether annual issuances will be a continuous affair.
Not many maturity points- As of now, IIBs will have tenor of 10 years only and therefore it
does not provide alternative maturity points .In such scenario it may not be able to meet
diverse market demands.
No Tax Concession- There will not be any tax concessions for investing in these bonds.
Presumably, tax will be deducted at source on these investments. This could be a major
shortcoming.
Unlikely reductions in Gold imports- According to estimates, 2/3rd of gold imports go into
making of jewellery products. Therefore it is not possible that introduction of sovereign bond
would lead to reduction in gold imports.

Conclusion:
The launch of IIBs is timely and appropriate from RBIs point of view as inflation has
moderated in the economy. The product will definitely help in diversification of products in
G-Sec market. However RBI has a much broader objective of diverting investors from
investing in gold and thus reducing gold imports. However is is very unlikely that this
objective will be met with launch of a debt instrument which has a very limited investor base,
lack of maturity options and no tax exemptions.

References:
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www.rbi.org.in
Economic Survey of India, 2013-14
Press Release of RBI dated May 15 and June 4, 2013
Union Budget, 2013-14
www.livemint.com
The Indian Banker, Volume VIII No.7, July 2013