On Tuesday, the Reserve Bank of India (RBI) will launch inflation indexed bonds. Retail investors can participate — up to 20 per cent in the first series for 2013-14 is earmarked for retail and mid-segment investors. The second series to be issued later this fiscal, around October, will be entirely for retail investors.

What do these bonds offer? Should you, as a retail investor, buy? Read on.

What are they?

Inflation indexed bonds are designed to protect your savings from rising prices (inflation). As prices rise or fall in the economy, returns on these bonds increase or decrease. This is unlike normal bonds, where returns remain constant. Last month, engineering major Larsen and Toubro issued inflation indexed debentures with an annual interest rate of 1.65 per cent. Assuming that the RBI’s inflation indexed bonds are also issued at this rate, how will they differ from normal bonds?

Say, you invest Rs 1,000 in a normal bond which also offers a rate of 1.65 per cent annually and matures in one year. After a year, you get Rs 16.5 as interest and the original investment of Rs 1,000 is repaid. There is no uncertainty here.

Now, an inflation indexed bond, of the kind being issued by the RBI, with the same terms, will give you more or less — depending on the level of inflation or deflation. Assume, for instance, that over the next year inflation is 7 per cent. The inflation indexed bond will give you Rs 17.66 as interest. The calculation is like this — the amount you originally invested is adjusted to take into account inflation, and on this revised amount, interest is calculated — (Rs 1,000 x 1.07) x 1.65 per cent which is Rs 17.66. On the other hand, if there is 7 per cent deflation (price decline), your interest falls to Rs 15.35 calculated as (Rs 1,000 x 0.93) x 1.65 per cent.

On maturity, along with the interest, you will be repaid the original investment or the revised principal amount, whichever is higher.

So, if inflation is 7 per cent, the amount you will be returned (besides interest) at the end of the year will be Rs 1,070 (Rs 1,000 x 1.07). If prices fall 7 per cent, the principal repayment will not be reduced to Rs 930; you will still be paid the original investment of Rs 1,000.

This way, inflation indexed bonds protect both the principal invested and the interest against inflation. In a deflationary scenario, the interest you receive will reduce, but the principal invested will be returned intact, given that the bonds carry capital protection.

Why now?

Over the past few years, high inflation resulted in negative real returns on financial investments such as bank fixed deposits.

The real rate of return on an investment is what you get from it (nominal return) minus the inflation rate. For instance, if the post-tax return on a bank fixed deposit is 7 per cent and inflation is at 9 per cent, the real return is a negative 2 per cent.

Negative real returns erode savings. This led retail investors to flock to riskier assets such as gold and real estate which have a reputation for delivering returns higher than inflation.

But the increasing demand for gold, most of which is imported, worsens the country’s current account deficit situation and strains the government’s finances.

The move to introduce inflation indexed bonds is meant to kill two birds with one stone — to offer retail investors a much-needed hedge against inflation, in the process hoping to wean them away from gold.

how it works

The interest rate (coupon) on RBI’s inflation indexed bonds will be a fixed real rate. This rate, which does not take inflation into account, will be determined through an auction and will remain constant for the bond tenor.

In the first series, the tenor will be 10 years. Interest will be paid half-yearly. Inflation will be accounted for through adjustments to the amount invested (nominal principal value).

The adjustment factor, known as the index ratio, will be based on changes in the wholesale price index (WPI). It will be calculated by dividing the reference WPI on the settlement date with the reference WPI on the issue date. The settlement dates are when interest is paid, principal is repaid or when the bond is traded. For instance, if the reference WPI on the bond issue date is 100 and that at the time of the first interest payment, six months hence is 104, then the principal will be multiplied by the index factor of 1.04 (104/100).

Say, the principal invested is Rs 1,000 and the annual real rate determined through the auction is 1.65 per cent. The interest to be paid for the half-year will be Rs 8.58 calculated as Rs 1,000 x 1.04 x 1.65 per cent x (6/12).

Reference WPI numbers will have a four-month lag. This is to ensure that changes, if any, are incorporated and that the final WPI is used in the calculations. For instance, the final WPI of January 2013 will be used as reference WPI for June 1, 2013, the final WPI of February 2013 will be used as reference WPI for July 1, 2013, and so on. For dates between the start dates of two months, reference WPI will be computed through interpolation.

Retail participation

According to the RBI, retail investors can participate in the first series through the non-competitive segment.

They have to indicate only the amount of their bids, and not the price at which they want to subscribe. They will receive allocations based on the price determined by institutional bidders. Bids can be put in by retail investors through primary dealers and banks, by opening a gilt account or demat account.

The links below have information provided by the RBI on inflation indexed bonds:

http://tinyurl.com/RBI-IIB-Announcement

http://tinyurl.com/RBI-IIB-FAQ

anand.k@thehindu.co.in

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