Following this issuance there will be two inflation-linked debt products floating in the Indian market. The first, a Wholesale Price Index (WPI) linked bond, was launched in June this year with a coupon rate of 1.44% real yield. Anecdotal evidence suggests that the WPI version, being the first of its kind, had not found many takers. Among other reasons for this low response includes its linkage to the WPI instead of retail level inflation as measured by the CPI.
The new CPI linked Securities offering therefore looks promising. The security, as stated above, would offer 1.5% plus the CPI inflation rate, compounded half yearly. An example of cash flows can be found on the RBI website. Note that this is an interest indexed bond where the adjustment for inflation comes through the coupons, i.e. the inflation rate is simply added to the coupon and the principal at maturity remains unchanged at 100; instead of a Capital indexed bond where the principal of the bond adjusts with inflation and coupon payments are calculated as a fixed coupon times the inflation adjusted principal. The WPI version launched in June is a Capital indexed bond.
Despite these differences in the structures of the two bonds, to get a rough estimate of fair value, it is worth comparing the 1.5% real coupon being offered by the new CPI-linked securities against the current market determined real yield of the WPI linked bond, both of which mature at about the same time. A back of the envelop calculation shows that 1.5% is 200 basis points (2%) lower than the current market real yield of the WPI inflation-indexed bond (at 3.5%). While, in recent times (post the global financial crisis of late 2008), the divergence between the two inflation measures has been more than 3% on average. If this divergence continues (debatable), the CPI-linked security should yield more than the WPI version (e.g. if average WPI inflation is 6% over the next 10-years and average CPI inflation is 9%, then the two would yield approximately 9.5% (= 6% + 3.5%) and 10.5% (= 9% + 1.5%)respectively).
Figure 1: CPI and WPI inflation since 2002
There are, of course, fixed income nominal instruments against which investors would compare the worthiness of investing in this product. As a simplistic rule, the product offers more value if the investor believes that average CPI inflation over the next 10-years (or the investment horizon) plus 1.5% is likely to be higher than the interest rate offered by alternative fixed income instruments. Projecting inflation however, may be difficult given the unstable CPI inflation observed over the last 10-years (see Figure 1). A range of fixed income options currently available to retail investors in India are shown in Table 1.
Taxation and Credit worthiness are other parameters worth focusing on. With regards to taxation, for investors in the high income tax bracket, tax-free bonds tend to offer better net returns over other available debt instruments. While, credit-worthiness is an important criteria if one is parking money for as long a term as 10-years (though early redemption after 3-years for non-senior citizens and after 1-year for senior citizens is also an option, but with a penalty)
More than the prospect of higher returns, it is the protection against inflation and portfolio diversification that should draw investors into the new CPI-Linked security. While there is understandable apprehension about the floating nature of cash flows of this asset, investors should consider the inevitable risk they take by not hedging their savings against inflation. The notion of leaving money under a mattress versus depositing in a bank has just gone one level further.
