Inflation indexed bonds, please :: Senior Manager, Motilal Oswal Wealth Management Business.in Business Line

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Inflation indexed bonds help in risk diversification, especially when price movement is uncertain.

The year 2011 has been a terrible one for investors. As if the global crisis wasn't enough, the RBI's successive policy rate hikes took a toll on economic growth which is now expected be less than 7 per cent.

The catalyst was inflation which has left common investors watching helplessly as their capital was eroded by negative real interest rates. Headline inflation, which hovered over 9 per cent-plus for 19 out of 23 months, became a headache for policy makers and the common public too.

The financial savings-to-total GDP dipped to its historic low of 9.7 per cent in 2010-11. It was in this context that the RBI put forward a technical paper on ‘Inflation Indexed Bonds' (IIBs) in October 2010.

The proposal suggests inflation indexed bonds, where the principal is indexed to the Wholesale Price Index (WPI) periodically while the coupon would be paid on this inflation-adjusted principal. Simply put, by subscribing to this bond, your portfolio is hedged against rising inflation.

HOW IT WORKS

For example, assume an IIB issued at a face value of Rs 100 with a real coupon rate of 4 per cent paid annually. If the cumulative inflation hovers at 5 per cent at the time of coupon payment, the principal calculated for the coupon payout will be Rs 105 and the coupon payment would be Rs 4.20.

If prices sink leading to deflation of 5 per cent, the indexed principal would be Rs. 95 and the real coupon payment Rs 3.80. This will be repeated every year. However, at the time of redemption, the principal repaid would be equivalent to its par value. It can't be less than Rs 100.

OVERSEAS INSTRUMENTS

IIBs are quite common in developed nations such as the US, the UK and Canada and have been have been finding support in emerging markets economies like Hong Kong, South Korea and Thailand.

While Hong Kong saw its first IIB launched in July 2011, which was oversubscribed, Thailand delayed its scheduled sale in May 2011. Among emerging nations, South Africa had its first successful issue in 2000 and since then, they have grown to a value of $ 400 billion.

In India, the RBI experimented with these bonds twice, once in 1997 and the second time in 2004. In 1997, only the principal was inflation indexed and not the coupon, while in 2004, both coupon and principal was inflation indexed to the WPI.

Both times, it failed due to many factors, the main being the lack of convincing benchmark and lack of depth in the bond market.

Even now, India is yet to take a decision in IIBs. Probably because this structure may not work in scenarios where the headline inflation remains high for an extended period. For much of last year, inflation hovered at 9 per cent plus.

The RBI probably fears that the auction-based sale may set higher yield expectations from buyers, making this costly in comparison to a nominal bond sale. Moreover, such bonds are focused on the retail customer, but in India, majority of bond investors are institutions.

IIBS SCORE OVER OTHERS

IIBs help in risk-diversification, especially when inflation is uncertain. It offers assured real yield over the maturity of the instrument. Market participants like pension funds and insurance companies can offer inflation indexed liabilities but they would require IIBs in with long terms of 25-30 years instead of 10-12 years as offered in its latest product design. Moreover, it would be a cost saving for issuers.

The data suggest that the weighted average cost of market borrowings through IIBs may be cheaper in comparison to nominal dated securities. The analysis also suggests that the nominal interest payouts would be anchored to the revenues of the government, leaving no mismatches on account of inflation. It will also help in gauging the market's inflation expectations, key to policymaking.

DOES THE MARKET NEED IT?

As the market prepares itself for a drop in inflation in the near months, the IIBs may make for a good option.

The recent announcement of CDS being operational from December this year is going to make the bond market even more liquid and deeper.

Currently, high inflation has prompted investors to invest in gold which is perceived as a hedge against inflation.

The rise in gold imports does not augur well for the Indian economy; it works against the domestic currency as we pay in dollars. Gold imports have led to a slide in the Indian rupee fuelling inflation.

Gold imports rose to 753 tonnes in H1FY12, an increase of 11 per cent. At $37 billion, a 44 per cent increase in value, this is a huge part of import bill for country like India, which still depends on capital inflows to cover its import bills.

At this juncture, IIBs make sense and it would help investors diversify their asset portfolio and save costs for issuers.

Moreover, investors will be able to participate in more productive assets rather than gold, which has cut down the financial savings dramatically.

(The author is Senior Manager, Motilal Oswal Wealth Management Business.)