Inflation Indexed Security

Posted in Finance, Accounting and Economics Terms, Total Reads: 108
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Definition: Inflation Indexed Security

Inflation Indexed Security is a type of security that provides a hedge against inflation. It takes into account inflation rate as well as deflation rate while paying the interest and also consider inflation while paying the maturity. Thus it protects the investors from losing the money or the saving due to inflation. They give periodic coupons just like a normal bond but they adjust their coupon payment and maturity amount by inflation this way the investor does not lose on their savings and thus get a real return. Real returns are defined as returns that are already adjusted with the inflation rate. Since they provide risk coverage so thus the coupon rate is less than what is actually given to normal securities. Thus the par value of the security rises with the increase in the inflation. To get full benefit from the Inflation indexed security it is important to keep the security till maturity period.


Advantages

1) Allows investors to earn return higher than the inflation, thus will get real returns

2) First the interest was linked to WPI but now interest is linked to CPI instead of WPI which is beneficial for the investors since WPI is negative.


Disadvantages

1) In case of deflation the value will fall, thus the whole concept of real returns fails and then the fixed deposits will give higher return since they have fixed interest rate.

2) The interest that are paid are taxable.

3) There is heavy penalty if money is withdrawn before maturity period so the investors have to wait for maturity to get full benefits

4) This is also lead to compromise with the liquidity

For example, there is an XYZ bond that is an inflation indexed security and maturity period is 10 years with principal 100 and coupon rate of 5%

PERIOD

YEAR

COUPON RATE

INFLATION INDEX

THE NEW PRINCIPAL BECOME

Coupon payments of not an inflation index bond

Coupon payment of XYZ security

1

2016

5%

100

100

5

5

2

2017

5%

105

105

5

5.25

3

2018

5%

110

110

5

5.5

4

2019

5%

112

112

5

5.6

5

2020

5%

115

115

5

5.75

6

2021

5%

127

127

5

6.35

7

2022

5%

133

133

5

6.65

8

2023

5%

139

139

5

6.95

9

2024

5%

145

145

5

7.25

10

2025

5%

150

150

5

7

MATURITY AMOUNT

 

 

 

 

100

150

So we can see from above example that the bond which is not inflation index bond is not giving any real return while the XYZ security is adjusted to inflation thus providing higher returns.

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