Sometimes the social application like Whats up can be fun to debate things. Yesterday was arguing with one of my friend on the imagesrecently announced inflation indexed bonds, a financial instrument which can act as a hedge against inflation by the RBI.

Before I describe their pros and cons Let us know what are they – They are the enhanced version of Capital Indexed bonds issued in 1997 by RBI. Capital indexed bonds provided inflation protection only for the principal while inflation indexed bonds provide inflation protection for interest payments as well. Theoretically, inflation indexed bonds could indicate the willingness of the government to maintain optimal Inflation numbers. 

After the initial auction, inflation indexed bonds are traded in the secondary markets. A normal government security bond carries an inflation risk which the inflation indexed bonds are free from. So the difference between the rates of nominal rate of return from a normal government security bond would denote the inflation expectations of the market. Monetary policy makers can take cue from these market expectations to control the inflation rates.

Now Lets compare the Inflation bonds with other debt products :-

Inflation risk has been a potential problem with fixed income securities, especially with the fixed maturity products. If the inflation rate is higher than the interest rate being received on the fixed income products, it diminishes the purchasing power of the consumer. Inflation indexed bonds are an efficient way to counter the inflation risk.

The main difference between fixed deposits and inflation indexed bonds is the principal adjustment and interest payment. In case of a fixed deposit, a pre-defined static interest rate is mentioned and at the end of the tenure an investor can withdraw the invested amount along with the interest rate accumulated. In case of inflation indexed bonds, the principal is adjusted to wholesale price index (WPI) and a fixed coupon rate or interest rate is paid on the periodically adjusted principal amount.

When compared to debt oriented mutual funds, inflation indexed bonds score higher in terms of capital protection. However, with the dynamics of secondary markets and redemption yet to be rolled out by the RBI, liquidity may remain a primary concern as of now.
Cons of Indexed bonds for retail investors :
currently inflation indexed bonds are linked to WPI. Instead of WPI, the consumer price index (CPI) stands as a better representative of the purchase power of individuals. As per the latest data, WPI is at 4.89 per cent whereas CPI is at 9.39 per cent. The differential between these two measures of inflation is substantial. From the retail investor’s perspective, linking the interest with CPI is more beneficial compared to linking it in WPI. Linking the interest rate with CPI will give the necessary advantage for both investors and the regulators. It can act as an alternative investment to gold as a hedge against inflation.

How does the Indexed bonds work :
The RBI is issuing inflation indexed bonds which are linked with WPI. The invested principal is adjusted as per the prevailing WPI rates and a fixed interest rate is paid on the adjusted principal.

Adjusted principal = [(inflation index at a given point of time) divided by (inflation index at the time of deposit)] multiplied by (principal amount)

Interest being paid = Adjusted principal multiplied by coupon rate.

To conclude : The dynamics of the secondary market trading of the inflation indexed bonds are yet to be defined by the RBI. These factors will help investor’s better gauge the performance of these bonds, I still feel the net tax return will be more on Debt Mutual funds and the Fixed Deposits.