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Inflation index bonds in India, will they work?

, April 26, 2014, 1 Comments

India- Inflation Index Bonds

The inflation index bonds which were introduced in the union budget last year have evoked a lack luster response. Inflation index bonds vary from traditional bonds in terms of returns. While traditional bonds offer a fixed return, if held to maturity, Inflation indexed securities target real returns for the investors. The real returns in economic parlance are returns earned after adjusting the inflation rate. Their returns are benchmarked to an index such as WPI (Wholesale Price Inflation), and CPI (Consumer Price Inflation).

Although inflation index bonds are relatively new in our country, they have been popular in the developed world. For instance in the UK they make up nearly one third of the public debt. In the US they constitute nearly 10% of the marketable debt .In 2012 the inflation linked bonds made up nearly two trillion dollars of issue, with the US, UK and France topping the charts.
However for the emerging markets they are relatively new.In recent years these markets have added substantial issuances of these securities. They make a substantial share to inflation index bonds.

Size of Inflation Index Bonds-MarketExpressSource: Barclays as of 28 February 2013

In India these bonds were introduced in 1997, where the bonds offered inflation protection on the principal amount. The product did not pick up, since these bonds did not hedge interest payments against the inflation benchmark.

The inflation index bond in their new avatar is a marked improvement, since it offers protection on both principal and interest payments.

The main feature of these inflation index bonds is its linkage with the CPI. The interest rates have two components, one is the fixed spread rate of 1.5% over the benchmark, and the other is the inflation rate, or the benchmark. By linking it to the inflation rate, investors are assured that inflation does not erode their savings. Every six months the interest rates are adjusted to the then prevailing inflation rate and the spread.

The idea of introducing these bonds was to give consumers an alternative asset which would insulate the investors against rising inflation.

The policy makers had hoped introduction of an asset that protects the investors against inflation would discourage the consumption of gold.

This government initiative was targeted for medium and small investors. The government had envisaged that it would mobilize resources to the tune of Rs. 20000 crores. The issue which was scheduled to close on 31st December 2013 had to be extended to March 2014 on account of lukewarm response by the investors. The issue failed to attract the stipulated amount

Various Reasons are attributed to it.

Lack of retail participation
Investment in these bonds has not been forthcoming for retail investors. Long tenure, lack of liquidity, and absence of a vibrant secondary market due to non-tradability of these bonds ensure that investments will predominately be led by institutions. A retail investor looks into these important parameters for investment:-
• Risk
• Return (adjusted for tax)
• Liquidity
• Predictability of returns.
• Convenience

The credit risk in these bonds is minimal, since they are backed by the sovereign government. The return risk is slightly higher since the benchmark inflation can go up and down. In terms of return, they stack up favorably against most fixed income instruments.

They score higher than FD since the return on FD is fixed. During inflationary times when interest rates earned on an FD is lower than the inflation rate, the investors end up earning a negative real return. Even compared to debt-oriented mutual funds, inflation indexed bonds score higher in terms of capital protection. Hence, they deserve to be a part of investors’ portfolio, like gold is.

The liquidity in these instruments also needs to be improved, to be attractive. In India, financial instruments are a ‘push product. They need to be pushed by the retail distribution channel to be bought by investors. Tax-free bonds floated by eligible corporates are a case in point.

The reverse channel also serves as a liquidity window when the investor wants to sell the bond. By listing these bonds on the stock exchanges in the retail debt segment, a fillip to liquidity can be given from the small time broker channel. Further, sufficient ‘commissions’ need to be given for the distributors to push these products, otherwise they might end up as the NPS (New Pension System), which is ideal to have, but never pushed.

Floating rate instruments are by themselves a new asset class in Indian investors’ investment lexicon and experience. The Indian investor has been wedded to fixed and predictable returns, or to ones that hold physical and cultural appeal like gold. To overcome these handicaps, a higher fixed premium (to cover at least savings bank returns) over the floating rate (inflation) benchmark can be thought of. This higher premium can also be used to incentivize distributors to ‘push’ these bonds. Once the retail investor catches fancy to these bonds, the premium can be reduced.

Despite governments efforts to discourage investment in gold, there has been very little thought and effort given to wean them away from it. All that has been instituted are quantitative controls and higher import duties, This has only served to drive the gold trade underground, into the smuggler’s hands. Although imports on gold have dropped drastically in 2013, there have been increase in smuggled gold. Nearly 150-200 tons of gold have been smuggled in India in 2013 as per the estimates of World gold Council.

Some thoughts on inflation index bonds have been presented above. The RBI and government are serious about developing for these inflation index bonds , especially for the retail investors .However half hearted attempts, ivory tower technical committees and turf protection oriented short term vision has stunted the design, acceptance and development of these instruments.
There have been similar cases like interest rate futures, which were launched in the past failed to gain acceptance , redesigned and launched recently.

Redesigning and re-launching these instruments, will not only develop the bond market but also act as some sort of control on government and help wean away investments in physical assets and gold. In order for this to be successful, current low hanging fruit like an established distribution network for mutual fund , insurance and stocks can be easily tapped into without much ado. This will also help in moderating the structural inflation cycles in India.

Even with these design changes gold will never lose its sheen in India because of the cultural appeal and cash economy. At best these instruments can act as a portfolio diversifier and taken up in small doses by investors.

  • P V Rajeev

    I think the best way to make these bonds popular in India is by making it tax free. or exempt from tax if kept for more than three years or so