Consumer inflation linked bonds finally here

The much-anticipated inflation indexed bonds, linked to consumer prices, will be available for sale for a week beginning Monday. Inflation Indexed National Savings Securities - Cumulative, as these bonds are called, seek to protect your savings from price rise, by offering returns over and above inflation at the retail level. Drawbacks on taxation and liquidity fronts dilute the hedge, but the bonds could still merit a place in your portfolio.

The deal: Only retail investors can buy these bonds. The minimum investment size is Rs 5,000. The interest rate is the sum of the prevailing inflation based on the combined consumer price index (CPI) and a fixed rate of 1.5 per cent annually. The inflation rate will be reckoned with a lag of three months, with the September CPI used in December, and so on. Interest on the bonds will not be paid out but compounded on a half-yearly basis. To illustrate, if CPI inflation is 6.67 per cent for six months, add 0.75 per cent to arrive at the interest rate (7.42 per cent). So, an investment of Rs 5,000 in December will earn interest of Rs 371 and stand at Rs 5,371 in June. This in turn will earn interest for the next six months based on the inflation during that period. This continues for 10 years (the bond tenure) when the principal and the compounded interest is get paid back.

Pros & cons: The bond’s unique selling point – that it tracks retail inflation – can come in quite handy, if retail level inflation remains high. In November, CPI-based inflation was 11.24 per cent. At this level, the pre-tax return on the bond works out to nearly 12.75 per cent, far more than rates on long-term bank deposits (9.25 per cent). But if inflation falls, the pre-tax return on the bond could be lower than that on bank fixed deposits.

Note that the tax on interest will also reduce your returns. After taxes, the 12.75 per cent pre-tax return on the bond will fall to 11.4 per cent in the 10 per cent slab, 10.1 per cent in the 20 per cent slab, and 8.8 per cent in the 30 per cent slab. That said, other safe investment options today such as tax-free bonds and bank fixed deposits also do not provide positive real returns (post-tax returns minus inflation). The bonds, however, carry no TDS and tax experts say retail investors can offer their interest income to tax either annually or at the time of maturity.

Liquidity on the bonds is not great either. Premature redemption is allowed after one year for investors above 65 years, and after three years for other investors. But if you redeem early, you will lose half the last payable coupon.

It is critical for your portfolio to beat inflation over the long-term and these bonds provide a partial hedge. The returns are better at lower tax slabs. But the bonds are not useful for regular income seekers. The issue is open till December 31. To invest, approach SBI and its associates, nationalised banks, HDFC Bank, ICICI Bank, Axis Bank and Stock Holding Corporation.