Inflation Indexed Bonds – what they really mean?
Ashish what are your views about IIBs?
My friend Kuldeep Chauhan asked me innocently with a spark in eyes, ready to grasp whatever comes out of my mouth in form of the answer.
To confess it honestly, I was taken aback by the question not because he wanted my serious views for the first time in my life but Inflation indexed Bonds (IBBs) had become a long lost concept in the Indian economy by now.
The whole exercise (IIBs) failed miserably in the Indian market in 1997; the first time bonds linked to inflation were introduced.
Therefore, I was of a view that they won’t ever see a comeback but Reserve Bank of India (RBI) is in a completely different mood.RBI is all set to release Rs 10 to Rs 20 billion bonds to foreign and domestic investors in the approaching month of June, this year.
However, the real question is whether these sovereign bonds are really worth a purchase?
How do they work?
IIBs are kind of bonds that take into account the current inflation level in the economy and automatically adjust themselves by an “inflation indexation factor” for each and every payment period.
This helps in covering any kind of loss in value of rupee due to inflation and the returns are way better than normal bonds.
Furthermore, considering the failure of IIBs the last time of its launch, this time they have been linked them with Wholesale Price Index (WPI) along with coupon rates that would be revised every four months.
Now answering the second part which asks how IIBs work.
Consider a situation where one pays Rs 100 for IIB that offers 7% a year.
Let inflation be 10%.Therefore if WPI index (which was 200 in the beginning) is 220 at present. Therefore, in the case of IIB’s principal goes up by this amount and similarly the interest.
Principal = principal at the issue time *(current WPI/WPI index at the time of issue)
The new principal is Rs 100 and interest paid out is Rs 110*7%= Rs 7.7 and similarly the principal and interest would be re-adjusted next year in accordance with the existing inflation level.
Nevertheless, the main point of consideration is whether the bonds will experience the rub of green this time around.
WPI numbers that have been released some days back are way lower than expectations and hence suggest that inflation is cooling down steadily. However, what pains is that the Consumer Price Index (CPI) is still hovering around 9.39% presently.
Therefore, on what basis RBI picked up WPI to be a parameter to gauge inflation completely ignoring CPI.
The ever increasing spread between both indices may prove detrimental to the interests of retail investors.
In addition, IIBs are projected to solve the Current Account Deficit (CAD) problem of India.However, the projection doesn’t seem to be too bright enough and those interested to know why must read my article on the very subject.
Other than that, investors (who are still lacking knowledge about these sovereign bonds) should be educated comprehensively about the concept as early as possible so that the purpose is solved and the mission is accomplished without any major glitches.