Impact Analysis of Inflation-indexed Bonds in India
Posted in Finance Articles, Total Reads: 2105
, Published on 20 July 2013
In recent budget-2013, our finance minister proposed the introduction of inflation-indexed bonds (IIB) with the aim of reducing gold imports (approx 162 tonnes in May 2013) which have adversely affected our current account deficit(CAD). Let us understand the need for introducing IIBs, their working and their impact on the economy in greater detail.
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What are IIBs?
IIBs are fixed-income instruments that pay a stipulated interest throughout the term period of the bond.The principal amount is adjusted by an inflation indexation factor for each interest payment period. The real return for the investor will be low in keeping with the inflation. The impact of inflation is higher for those who invest in long-term fixed-income bonds. IIBs will be of interest to the investors seeking to protect their long-term debt portfolio from the effects of inflation.Thus IIB’s help investors retain their purchasing power by acting as a perfect hedge against inflation.
Working of IIBs
Here's how IIBs work. Interest will be paid twice a year over the 10 year tenure. Principal will be indexed to the final wholesale price index (WPI) rate. The coupon rate will remain constant.
Let’s say Rs. 1000 crore are invested in IIBs. The first issue of IIBs was at a WPI level of 170 and a coupon rate of 1.44%. A year later, let’s say the WPI is 190. The principal will be revised to Rs 1,000 crore x (190/170), or about Rs 1,118 crore. The interest will amount to 1.44 % of Rs 1,118 crore, or about Rs 16 crore. If the WPI becomes negative, the principal would be revised down. Practically, this recalculation will be done and interest will be paid every six months.
To ensure that investors do not suffer a loss if WPI becomes negative, higher of original base value and adjusted principal value will be paid at maturity. However, the probability of it happening is practically nil in an emerging economy like India.
On maturity, the investor would get back the higher of the adjusted principal or the face value.
Calculation of Index Ratio
The IR (index ratio) is computed by dividing reference WPI on the day of maturity by reference WPI on the issue date, and the final inflation data based on the Wholesale Price Index (WPI) will be used for providing inflation protection.
If there is a revision in base year for WPI series, then base splicing method would be used to construct a consistent series for indexation. Final monthly WPI will be used as reference WPI for 1st day of the calendar month. Values for intermittent days will be calculated using interpolation. Indexation lag will be of four months as final WPI is available with a lag of about two and half months and 2 months data is required for interpolation. For example, October 2012 final WPI will be taken as reference WPI for 1st of March 2013 and November 2012 final WPI will be taken as reference WPI for 1st of April 2013.
Formula used for interpolation is
Ref WPIM = Ref WPI for the first day of the calendar month in which Date falls, Ref WPIM+1 = Ref WPI for the first day of the calendar month following the settlement date, D = Number of days in month and t= settlement date
Ref WPI Interpolation
Calculation of daily price enables determine accrued interest and thereby the dirty price of the bond.
Cash flows structure of IIBs vs.Traditional Bonds
The cash flows generated from IIBs are relatively lower as compared to those of traditional bonds during the interest payment phase. However, since the principal of IIBs is adjusted against inflation every year, the final inflow of principal along with the interest is higher than that of the traditional bonds. This difference depends on the rate of inflation during the term of the bond.
Implications for investors
One advantage of the IIB is that it not only adjusts the interest payments to inflation but also the principal repaid to the investor at the end of the tenure of the bond.
Inflation-linked bonds are directly linked to changes in inflation, whereas government bonds are negatively correlated to the inflation rate.On the other hand, stocks, real estate, and commodities are only indirectly connected to the inflation rate, and this correlation is highly unstable. Particularly in periods of stagflation, only inflation-linked bonds offer optimal protection against inflation. As a result, a combination of the two asset classes appears to provide consistent and positive performance.
Performance of different asset classes
Source: Bridgewater Associates for the period 1926 to 2010
Over the long term, inflation-linked bonds have approximately the same returns as traditional bonds with lower volatility. This is mainly due to the fact that returns on traditional bonds are based on nominal interest which is highly volatile compared with returns on IIB’s (based on real interest which changes less over time) Thus, inflation-linked bonds can be, to a certain extent, superior to traditional bonds from a portfolio standpoint.
The above graph clearly highlights that returns on equities and inflation linked bonds are complimentary in nature. Hence for an optimum portfolio, one should mix equities with inflation indexed bonds to reduce the risk of the portfolio and thereby improve the Sharpe ratio as compared to having mix of equities and nominal bonds.
The instrument will also be traded like any other government security, which gives investorsa scope to exit their investments.
However, the bonds have been indexed to the WPI and not the Consumer Price Index (CPI). Consumer prices matter to them in day-today life than wholesale prices. While WPI has declined below 5%, CPI continues to be 4-5 % points higher.
Although inflation-indexed bonds prove beneficial during times of high inflation, they generally underperform when the economy goes through a deflationary phase and prices come down. In such a situation, the IIB will give lower than the coupon rate because the principal would get adjusted below the original value. However, this is only a theoretical risk. A reduction in wholesale prices is not even a remote possibility in India
In practice, inflation-linked bonds remain substantially less liquid than regular government bonds, in spite of growing markets and increasing liquidity in recent years.
Implications for government
IIBs seem to be to improve the choices available to investors and to wean away households from the gold obsession, thereby reducing the CAD.
First Auction of IIBs in India
The total issue size of inflation indexed bonds is Rs. 12000-15000 crore for the FY 2013-14 as part of the government borrowing programme. It forms approx 2.5-3% of the total borrowing target (Rs. 4.84 trillion). The 1st tranche of IIB’s issued on 4th June (Rs 1000 crore auction) was oversubscribed 4 times.
Key parameters of auction on 4th June
Rs 1000 crore
WPI based inflation
No of competitive bids
Institutional investors bid amount made
Rs 4616 crore
Institutional investors bid amount accepted
Rs 985.94 crore
Retail investors bid amount
Rs 14.06 crore
What’s in the pipeline?
First series of the IIBs will help in determining the coupon rate for the bonds by means of auction. This will help in benchmarking the IIBs. Based on the experience in initial issuances, another series of IIBs for the retail investors is proposed to be issued around October.
Presently, the IIBs are linked to WPI since the RBI has been basing its policy on WPI. Once India works out how to construct a representative and robust consumer price basket, bonds linked to CPI can be issued subsequently.
The RBI is keen on making active secondary market participation for Inflation Indexed Bonds to provide ample liquidity. The central bank auctions this first tranche especially for institutions to create demand for IIBs and help in making them tradable in the secondary market.
This article has been authored by Tejas Parekh And Parth Mehta from SIMSREE