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All about Inflation-Linked Bonds For Indian Retail Investors

Inflation Linked Bonds are basically framed to provide protection against inflation to the investors. They are the best replacement of gold investment, the benefit is that the principal amount also increases with the inflation, through it inflation risk is also minimized.

It was first issued in 1780 by Massachusetts Bay Co. In India RBI has designed it with government of India and will be launching it in month of May. About ILBs RBI has stated that to “introduce instruments that will protect savings of poor and middle classes from inflation”. Maturity period given on these Bonds by RBI is 10 yrs.

Inflation Linked Bonds (ILBs) are coming up as an avenue for those who are planning to invest in gold as the main aim of these bonds is to increase savings from investors and to discourage investment in gold. It will also protect the savings of poor and middle class people and will push them up to invest in Inflation Linked Bonds (ILBs) rather than in gold as in ILB’s, with the increase in principal amount the amount of interest also increases.

RBI will issue Inflation Linked Bonds of Rs 12000cr to 15000cr. In current financial year i.e 2013-14.

These 10 year bonds will offer a fixed coupon rate and their principal value will be linked to the Wholesale Price Index (WPI). Which means the principal value of the bonds will adjusted according to the prevailing WPI (In later stages it may get linked to CPI). They will be sold in tranches of Rs.1,000 crore to Rs.2,000 crore starting with the first sale on 4 June. As per R. Gandhi, executive director, RBI, these bonds will be reissued every month after deciding their principal based on the inflation numbers.

inflation linked Bonds

Types of Inflation Linked Bonds

The Canadian “Real Return Bond”

The British “Inflation Linked Gift”

The new US Treasury “Inflation Protected Security”

The first series of these bonds will be open up for all the investors like institutions, insurance sector etc. but from October onwards it will exclusively for retail investors.

These ILBs are having unique features as,

  • They are exempted from income tax,
  • They are having low risk investment,
  • They are less volatile than actual bonds.

“Thus these bonds will provide inflation protection to both principal and coupon payment. At maturity the adjusted principal or the face value, whichever is higher will be paid” said RBI. So investors now can also consider ILBs as their investment rather than investing in gold and nominal bonds.

Are Inflation Linked bonds a good Investment option?

Inflation protection is one of the main goals of investment management in India these days. This focus has gained more interest in wake of recent rippling effects of economic slow downs. The poor performance of stocks and government bonds in times of economic down turn has created the market for inflation-linked bonds.

The aim of inflation-linked bonds is to guarantee purchasing power by linking returns of bond’s to inflation directly. Payments in such a case can be in two parts: payment for the actual interest that is predetermined at the beginning of the term, and compensation for the loss of purchasing power (or increase in inflation) that may be incurred. In such bonds, the real income over the term is certain, whereas the nominal income is determined later (depending on WPI/ CPI).

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There are advantages as well as disadvantages of inflation-liked bonds.

Disadvantages Of Inflation Linked Bonds

Most importantly on the disadvantages side are two primary arguments.

  • There are doubts that excessive use of inflation-linked bonds could considerably fragment the market. As a result, the liquidity and marketability many other existing investment options and instruments would decline,and lead to sizeable bad debts for financial institutions.
  • The second point of has been put forth by central banks from different countries. The central banks have long feared that businesses and other market participants could become immunized against high inflation rates in the event of introducing inflation linked bonds. This immunization would undermine the integrity and worth of economic policy of the country.

It is for this reason that many governments and central banks have issued inflation bonds after much consideration.

Advantages Of Inflation Linked Bonds

  • Many advocates however, view inflation-linked bonds from a very optimistic perspective. They have opinion that inflation-linked bonds enhance the credibility of central banks and countries.
  • In times of high public debt and soaring inflation governments and central banks are limitlessly criticized and pressurized regarding their policies and interest rate. If inflation linked bonds become a reality a lot of such burden can be siphoned off from their shoulders earning them more credibility.
  • Inflation linked-bonds also provide a means for much desired inflation protection;as they are risk-minimizing vehicles that provide for relaxed retirement planning. Such bonds have lower interest rates and as a result lower financing costs, any investor can easily consider them as an option.

It wont be an over statement to say that inflation-linked bonds are a type of securities that guard the purchasing power of the investment.

Before investing in inflation- linked bonds, investors should clearly examine the technical details associated with them. Two main technicalities are the calculation of the index ratio and protection against deflation. The index ratio is calculated by the issuer on a daily basis and is utilized for bond trading.

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