It may be better to give a skip to the first series of inflation indexed bonds, while watching out for future issues. Here’s why.
LINKED TO WPI, NOT CPI
Being issued by the Reserve Bank of India, these bonds no doubt provide a safe, good way to start hedging against inflation. Deflation in India is unlikely, so there should be little worry about returns declining over the tenor of the bonds.
But in their current form, the bonds provide only a partial hedge against inflation and not a perfect one. That’s because they are linked to the wholesale price index (WPI) and not to the consumer price index (CPI). The RBI acknowledges that it is the CPI that reflects the inflation people face at large.
Says Rajesh Iyer, Head-Investments & Family Office, Kotak Wealth Management, “As of date, the challenge for an individual investor is that he is exposed more to CPI rather than WPI. Hence inflation indexed bonds may not be a perfect hedge against inflation.”
According to Pawan Agrawal, Senior Director, CRISIL Ratings, “The retail investors will find it more acceptable if the return on these instruments is linked to CPI, which is more relevant at the retail (or at the consumer) level.”
The RBI has indicated that in the future when the CPI stabilises, it may consider launching inflation indexed bonds linked to it. Till such time, these bonds are likely to be linked to WPI.
Inflation in April as per the consumer price index was 9.39 per cent, almost double the reading as per the WPI (4.89 per cent). The gap between the two has been widening over the past few months since prices at the wholesale level have been declining faster than that those at the retail level. If this trend continues, the ability of the current series of bonds to provide a complete hedge against inflation weakens further from the point of view of a retail investor.
TAX ASPECT
Inflation indexed bonds do not offer special tax concessions. So, both the interest received and the capital gains on the bonds will be taxable. Tax will reduce the ‘real’ interest (likely to be between 1.5 and 3 per cent annually) from the inflation indexed bond.
It is only towards bond maturity that a retail investor gets to realise the full advantage of the inflation protection offered by the inflation indexed bonds. On maturity, you will be repaid the adjusted principal amount which takes into account cumulative inflation for the entire tenor.
This will be higher than the nominal principal repaid in a normal bond or bank fixed deposit. But the regular interest received is much lower than that for bank deposits or other debt, because they reflect ‘real’ rates.
While capital gains (the excess of the adjusted principal over the original investment) will be taxable, the indexation benefit available on long term capital gains should lessen the tax burden significantly.
Inflation indexed bonds will be traded in the secondary market. Profit on sale will attract capital gains tax.
WISE TO WAIT
Inflation indexed bonds provide the best utility when inflation is rising. Currently, inflation in the country is moderating and this takes away some edge from the hedge. But given the long tenor of these bonds, one should take a long-term view of how inflation will pan out in the coming years. It is in this context that inflation indexed bonds should find a place in a retail investor’s portfolio. It may be best to time a buy in these bonds with an upward movement in the inflation rate cycle.
The RBI has said that the product structure of the exclusive series of inflation indexed bonds for retail investors will be finalised in due course. It seems wise to wait for this.
What’s the alternative?
Bank fixed deposits up to Rs 1 lakh are safe alternatives. Currently, the best rate offered on such deposits of more than 5 years is 9.25 per cent annually. On a post-tax basis, the real return on these deposits considering WPI-based inflation works out to 3.4 per cent for investors in the 10 per cent slab, 2.5 per cent for those in the 20 per cent slab, and 1.5 per cent for those in the 30 per cent slab. This indicates that an inflation indexed bond which offers a real rate of 2.5 per cent or less may be worthwhile only for investors in the highest (30 per cent) tax slab. Others could consider investing in comparably safe bank deposits for better post-tax real returns.
But this is assuming that inflation rates will not rise from here. If they do, this equation will change in favour of inflation indexed bonds.
Gold, a favourite of retail investors, delivered handsomely and beat inflation over the past few years. But gold does not protect capital and prices can correct from your entry levels, as they have done in recent months. Besides, gold returns are entirely from capital gains with no regular cash flows as from inflation indexed bonds.
Real estate also proved a rewarding investment in the past. But similar to gold, future returns are not certain, and prices could also fall. Real estate could generate regular rental returns. But this is a big-ticket investment and cannot be acquired in small lots.
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