Inflation Indexed Bonds- Is it really a buy for you?

Inflation! Whenever we talk about the inflation; the first question, we wary ourselves with, is that, is there any risk free instrument or avenue of beating this ever increasing inflation? What I mean from risk free is; that calculated risk which one rational individual takes, when he invests in real estate or direct equity segment etc. Till few months ago, there wasn’t any, barring conventional Fixed Deposits (FDs) or Recurring deposits (RDs) (which are technically inefficient to fight with inflation).

Finance ministry in its last finance bill promised that government will take proactive steps to control inflation. Ever since that announcement, the option of floating Inflation Indexed Bonds (IIBs) was hovering over the market. The importance of this very subject can be understood from the recent statement of RBI Governor Mr. Raghuram Rajan which is stated as below.

 “Inflation is a disease. Industrialists complain about high rates but we don’t have a choice but to keep them high.”

Before we can come down to nuances of IIBs, it is important to understand its mechanics.

The basic structure of IIBs offer benefits in two forms.

• Real coupon rate or Interest rate
• Inflation rate

 Let’s understand this with the help of an example.

Suppose if you have invested Rs, 10 Lacs in IIBs, coupon rate is 2% and inflation rate for the first year is 10%. Then, your actual payout for first year will be Rs. 20,000 (2% of 10 Lacs) and rest 10% will be paid only at the time of redemption. However, your payout in second year will be Rs. 22000 (2% of Rs. 11 Lacs, (principal adjusted by inflation rate which is 10%).   

Before launching IIBs, it was said that real coupon rate will be paid on regular basis and inflation component will be added to the principal every year and will only be paid at the time of redemption. In this scenario, you will get the inflation component of your investment at the time of redemption only. Hence, the idea was not only to secure your principal from the inflation, but to increase your annual real payout marginally.

IIBs were designed in a manner that real coupon rate over and above inflation rate was to be arrived at via competitive bidding. Hence, the interest of large investors was mainly taken care of and clearly ignoring retail investors. It was also announced that IIBs will be listed in the wholesale debt market and on stock exchanges as well.

Surprisingly, it was not launched by the RBI for controlling inflation, so what went wrong with IIBs?

Even after being so attractive apparently, IIBs didn’t get the response RBI was looking for. Now you must be thinking what could have been the reason? Well, the reason was very simple, IIBs were coupled with the Wholesale Price Index based (WPI) Inflation and not the Consumer Price Index based (CPI) Inflation. As we all know, it is the CPI inflation which is the cause of worry for the investors and not the WPI inflation. Also, WPI inflation is always lower than the CPI Inflation, at least in context of Indian economy.

Hence, seeing the cold reaction from the market RBI pulled its hand out of IIBs and started thinking of a new warrior to fight with inflation for investors. Now, if you are thinking that I am here to KISS (Keep It Simply Social), then, you are wrong. This blog is intended to bridge the gap between reality and illusion of IINSS-C and help you to decide whether you should purchase it or not.

Features of IINSS-C

After failure of IIBs, RBI launched Inflation Indexed National Saving Securities-Cumulative (IINSS-C) to attract the Retail investors. This time IINSS-C was linked to combined CPI (not only CPI); since idea was to attract the retail investors, it avoided any competitive bidding as announced earlier and it came up with a mark-up of 1.5%.

Here are some features of IINSS-C which will give you an overall idea about this product.

It sounded quite well because currently WPI and CPI were hovering around 7.2% and 10.4% respectively.  With the inflation rate around 11% and coupon rate of 1.5% (along with the benefit of getting coupon rate on inflation adjusted principal every year), it was not at all a bad option.

The real benefit was that if inflation would have increased every year, coupon rate would also have increased. Above all these advantages, it was to get interest accrued and compounded every half year. But twist in the tail was waiting for all of those who were thinking IINSS-C as newly found investment arena. It was actually designed in less tax-efficient manner and it was not listed on stock-exchange unlike its earlier version (IIBs). You need to look into the taxability part once before you decide to have a shot to it.

Taxability of IINSS-C

This is an important part of our discussion as you have to pay tax on earnings from this particular instrument as well and your decision to invest into it cannot be made without considering its taxability.

In the below table, we have taken three cases where we can see with increase in inflation, there is an obvious increase in return also. But this return is without adjusting taxation part.

Effective return which IINSS-C apparently offers (without any taxation)     

Gross Return= Inflation rate during the year + Mark up (fixed).

Real Return is different from Gross return because interest will be compounded in every six months.

 

Wake up Call!

If decision of investing into this instrument would have been such a cake walk as it appears from the above table; well, then I wouldn’t have been writing this blog. Frankly speaking, we have a habit of seeing our benefit with sort of overview tendency. We do not bother ourselves to look deeper into the matter. So let’s have a close insight to it.

With Inflation 8%, 9% and 10%, and mark up of 1.5%, IINSS-C gives you 9.50%, 10.50% and 11.50% respectively and after taking compounding effect 9.72%, 10.78% and 11.83% respectively.  If you fall in higher tax slab, the returns thereof will be on slide from so called bonds which are there to protect you from the inflation. To understand it better, please see the graphs explained below which are self explanatory.

Graph 1: Tax Adjusted returns for different slabs                                                                    

 

Graph 2: Real Returns after adjusting inflation

Now it’s pretty clear from the graph 1 that higher is your tax bracket, lower is returns from these bonds. So it is not something lucrative for individuals earning more than 10 Lakhs per annum. Now question arises whether inflation part of interest is your real earning? No, it is actually like give and take, hence gives illusion only that you are getting over 10% during high inflation era. Inflation part of interest is mere compensation; it’s not a real earning for you. If you use to purchase a tea bag for Rs. 10 and after a year it costs you Rs. 11, then you would be getting compensation if you would have invested in these bonds.

Hence, the real return from the bonds is actually negative for all individuals except those who have no income during the year or those falling in 10% tax bracket. (See Graph 2)

Conclusion

• It’s a clear no for those who have investment horizon for less than 10 years’ time.
• Early redemption allowed only after 1 year for senior citizens (more than 65 years of age) and for rest its 3 years. If you withdraw after minimum lock-in-period, it would attract penalty as it happens in case of FDs.
• If inflation increases every year, it could be beneficial for lower income group people only. But in case, it doesn’t happen; you will get zigzag returns.
• Big X-factor is that return to be given every year will be given on inflation adjusted principal of that particular year. This will increase return marginally if inflation also increases every year.
• RBI is thinking to increase maximum investment in these bonds to 10 Lakhs (presently 5 Lakhs). There are also talks of bank giving loans against it, but no official version is there to rely upon.
• If you are earning more than 10 Lakhs per annum or you come under super-rich category, you can think to purchase tax-free bonds instead of it, since right now interest rates are on higher side and they are listed on stock exchange also.

I hope this would help you approach better in Inflation Indexed Bonds.