Inflation Indexed Bonds - A boon or bane for the Aam Aadmi?
Posted in Finance Articles, Total Reads: 2413
, Published on 05 October 2013
With all the hype and hoopla surrounding the launch of the Inflation indexed bonds (IIB), it remains to be seen if this latest financial instrument launched by the government helps in reducing India’s current account deficit (CAD), assists the Government in fulfilling its mid-year borrowing program and provides any hedge to the citizens against the double edged sword of inflation. This is India’s second tryst with IIB’s – the first being launched way back in 1997. (capital bonds).
image:idea go, freedigitalphotos.net
The first tranche of Rs. 1000 crores was launched on June 4, 2013. Buyers put in bids worth 4.68 times the Rs.1,000 crore. RBI, the central bank set a real yield at 1.44% for the 10 year government security maturing in 2023 much lower than the market expectations of around 1.7%. 1.44% is the premium they are offering over the inflation, which means these bonds will yield higher in terms of purchasing power parity compared to similar tenure nominal bonds. With a real yield at 1.44 percent, the coupon rate will be a jot above 8 percent. The nominal returns of the inflation indexed bonds have been linked to the Wholesale Price Index (WPI) which stood at 7.31% in January, 2013.
Before being traded in the secondary market, the IIB’s are being offered to institutional investors via the bidding process so that the bonds discover their price and market support on the basis of supply/ demand (buy/ sell) orders. The interest/coupon will be fixed initially on the basis of bidding by investors. Auction for IIB’s will be held on the last Tuesday of every month. The IIB’s will be offered exclusively to retail investors from October.
The Government plans to borrow between Rs.10, 000 – 15,000 crores in the current fiscal as part of its mid-year borrowing program. The government plans to raise this money by launching tranches of Rs.1000- 1500 crores over the next 12 months. The GOI attributes the launch of IIB’s to curb the import of gold which stood at a whopping $15 billion in the first two months of the current fiscal and about $7.5 billion in April. This is a huge burden on India’s burgeoning CAD which touched a record high of 6.7% of the GDP in December, 2012 and was at $18 billion in April 2013 due to a 17.4% increase in gold imports. The average quantum of monthly gold imports so far this fiscal has been 150 tonnes. This is almost double the monthly average of about 70 tonnes last fiscal.
Some of the salient features of IIB’s are listed below:
Tenor of 10 years with semi-annual interest payments.
Coupon rates linked to WPI instead of CPI with a 4 month lag. Firstly, WPI does not track the price of services and is skewed with respect to CPI. Secondly, the four month lag in WPI will not reflect the current inflation scenario. WPI in India in April stood at 4.89% vis-à-vis CPI which stood at 9.39%.
Principal adjusted to reflect fluctuation in inflation index and coupon payments based on the adjusted principal.
Upon maturity higher of adjusted principal or face value will be paid to the investor.
Portion of non-competitive bidding for retail investors has been raised from 5% of the notified value to 20% of the notified value. Hence, in a tranche of Rs. 1000 crore, Rs. 200 crore would be allotted for retail investors.
No tax benefits. Tax on IIB applicable as on other government securities. The excess of inflation adjusted principal over the original issue price would be in the nature of premium on redemption and as such should be taxed as 'capital gains' and the fixed coupon paid to investors would be regarded as 'interest income' .
Short term capital gains
Long term capital gains
**Applicable to interest received on or after June 1, 2013 but before June 1, 2015. In any other case, the interest shall be chargeable at the rate of 20%.
FII’s investment in IIB’s will form a part of the $25 billion cap imposed on them on their investments in G-secs.
In India most nominal bonds are subscribed to by banks, insurance companies and mutual funds. Hence, the investment of banks in IIB’s will be considered as a part of their SLR (Statutory Liquidity ratio) requirements.
Calculations pertaining to IIB’s:
Step 1: Calculation of Inflation Index ratio = WPI reference on settlement/ coupon payment date
WPI reference on issue date
Step 2: Calculation of inflation adjusted principal = Face value of the bond * inflation index ratio
Step 3: Calculation of interest payable = Adjusted principal * Coupon rate
It is widely believes that IIB’s may take some time to taste success given the value gold adds to one’s portfolio. Moreover, a majority of investors in India purchase gold with a long term view and not merely for investment purposes. Even when gold peaked to the Rs.32,000/ 10 grams level, hardly did we see any major selloff in the markets indicating that investment/ hedging is not the major purpose for which we Indians buy gold. In India, gold is considered auspicious and is bought for a wide range of purposes. Hence, introducing IIB’s to curtail gold purchases may take some time.
The article has been authored by Rahul Radhakrishnan, LIBA Chennai.