Are RBI's inflation indexed bonds a hit or a miss?

Inflation is the biggest risk that any saver/investor faces. Inflation is the general increase in price level and thus over time, inflation erodes the purchasing power of the money that you have today.

Let's say, you have INR 100 with you currently which is exactly enough to buy the goods and services you wish to consume. If the inflation in one year's time for those items of consumption happens to be 10%; then the price of those items would rise to INR 110. Thus the INR 100 that you have with you in cash has lost its purchasing power to the extent of inflation.

In order to try and maintain the purchasing power of your cash, you need to invest in asset classes or in instruments which are expected to grow in value at least at the pace of inflation every year.

For eg: if that INR 100 can be invested in a bank fixed deposit (FD) at an interest rate of 10% p.a, the value of that INR 100 at the end of the year would be INR 110 which is similar to the increase in price level of INR 110. Thus, with that investment even in one year you would be able to maintain your lifestyle and consume the same goods and services as before.

But what if the rate of inflation is higher than 10%; say 15% and the saving instrument available still gives only 10% p.a. Well, this is exactly the situation that an average Indian has been facing over the past 2-3 years. The rate of inflation has been consistently higher than the returns earned on investments, which then means that in spite of investing your cash, you are unable to purchase the same basket of goods and services as last year.

In investment parlance, this is referred to as negative ‘Real’ rate of return; i.e the return of 10% on the FD is lower than the 15% rate of inflation, thus giving the investor a negative 5% ‘Real Returns’ (actual returns when adjusted for inflation). So how does one then tackle this situation? Are there alternatives?

Historically, returns from deposits, bonds, post office savings (ala fixed income instruments) haven’t consistently been able to beat the rate of inflation. Indian equities, when invested over a long period of time, have shown positive Real returns, but that has unfortunately come with very high volatility. Meaning the returns are not a straight upward line but it has several ups and downs leading to periods of very high positive and negative real returns.

What if you could invest in an instrument, where the returns are linked to the level of inflation? Globally, there are instruments know as Inflation indexed bonds (IIBs) or Inflation linked bonds (linkers) where the interest rate of that bond (also called the coupon rate) is linked to the rate of inflation.

On Tuesday 04 June 2013, the Reserve Bank of India or RBI released the first series of these much awaited Inflation Indexed Bonds or IIB’s in India. The first issue was for INR 1,000 crores of a bond with 10 year maturity and needless to say saw huge interest from institutional investors.

So what are IIB’s, how do they work and should and how can a retail investor invest in them?

What are IIB's?

IIB or Inflation Indexed Bonds are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. In the current Indian context, the bonds would be issued and traded at a ‘Real yield’ and the principal of the bond would be adjusted to the Wholesale Price Index (WPI).

For eg. The IIB issued on 4th June was issued at a ‘Real’ Yield of 1.44% which will be fixed for the life of the bond and the regular interest payments would then be (1.44% * (Adjusted Indexed principal/100). This adjusted principal would be determined from the WPI Index. So as the WPI index increases due to inflation, the actual interest payments would be higher as the Adjusted Principal would also increase.

Inferring from the market levels, since the normal nominal yield on the 10 year government bond was around 7.25%, the market by bidding for the IIB at a ‘Real yield’ of 1.44% seems to expect that WPI inflation would average around the 6% mark. (7.25% - 1.44% = 5.81%). The value of the IIB thus then depends on the expected inflation and the current nominal yield of a normal 10 year (similar maturity) government bond.

• Confusing and complicated isn’t it? but don’t worry and don’t stop reading!!

As seen above we believe that in the current form of a bond issuance, the IIB’s are a bit too complicated and unsuitable for a retail investor to understand. Here’s why:

The investor receives the coupon in ‘Real terms; but as seen above the Real yield of 1.44% is far lower than existing FDs at nominal rates of 8%+. Of course, the coupon is adjusted for inflation but the interest received would be initially lower than interest from nominal FDs and hence will not be seen as ‘attractive enough’ by the retail investor. The bond markets are institutional in nature and retail investors would find it difficult to participate in these issuances of IIBsThe tenor at 10 years is, we believe, a bit too long from a retail investors/ pensioners perspective The inflation measure is WPI rather than CPI, which is the actual measure of inflation.

So what should you, the investor, do?

The government and the RBI are planning to launch a separate series of inflation bonds for retail investor by October 2013. We believe that if the inflation bonds follow the following parameters, they would be hugely successful and meet the objective of providing investors with a credible and simple solution to manage inflation risks:Instead of a bond, the Inflation indexed instrument for retail investors should be in the form of Deposit or Certificate or savings bonds. For eg. If the National Savings Certificate (NSC) or RBI savings Bonds are also available with inflation indexation, retail investors/ pensioners / senior citizens are more likely to invest as it is a widely available and accepted product.

The tenor should be 5 years instead of 10 years The interest rate on the bond should be a combination of a fixed rate plus the inflation rate. This would be easy to understand as against the concept of the real yield and principal adjustment on an IIB. The government can announce the fixed rate and inflation rate applicable from time to time The inflation index used should be Consumer Price Index (CPI), as it is a more relevant measure to track a common mans inflation.Interest payments should possibly be made monthly, adjusted to the relevant inflation rate plus the original fixed rate. This would help investors who depend on monthly income from their investments for meeting their regular expenses.

Thus, investors should wait for the retail inflation linked issuance to come about and if it is simple to understand and meets the above specifications and your requirements, you should think about investing a sizeable portion of your fixed income allocation into these instruments.

The good thing about having these instruments, apart from helping you to manage inflation, is it also puts pressure on the government to manage inflation and enact good governance/policies, so as to keep their borrowing costs under control. Else in a period of high inflation expectations, investors would shun all other products and flock to the Inflation linked bonds/certificates thus increasing the interest burden of the government.

Thus it is an extremely necessary instrument, much delayed in India, but if designed cleverly would actually offer a credible option for investors like you to manage inflation and protect the purchasing power of your hard earned savings.

Disclaimer, Statutory Details & Risk Factors:
The views expressed here in this article constitute only the opinions and do not constitute any guidelines and recommendation on any course of action to be followed by the reader. The views are meant for general reading purpose only and are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the readers. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and opinions given fair and reasonable. Recipients of this information should rely on information/data arising out of their own investigations. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.