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Monday, January 10, 2011

Afraid of inflation? Inflation-indexed bonds may bring respite

Inflation scares no one more than those living on interest income. The news that food inflation is hovering above 18% must be giving them sleepless nights. The trouble is that though interest rates have risen marginally lately, they are nowhere near the actual rate of inflation. Worse, the inflation number that is bandied about is mostly based on wholesale prices. If you actually include the consumer price-based inflation (considering we don't buy things from the wholesale market), things would indeed look unpleasant.

That is why we are all ears when there is talk about inflation-indexed bonds (IIBs). The Reserve Bank of India (RBI) has published a discussion paper on IIBs in December to obtain views from the public and market participants on the product.

Why are these bonds such good news?

Unlike your regular FD or bond, the principal is indexed (or adjusted) to the inflation periodically and the interest is paid on this inflation-adjusted principal. Simply put, your investment is hedged against rising inflation.

Also, the implications of having IIBs in place are much bigger. If these bonds really hit the market, one may soon have a host of products such as inflation-indexed pension plans, inflation-indexed insurance and mutual funds that may allow one to protect capital from the evils of inflation.

What's the interest

Still not clear? See the illustration: The government issues a 10-year bond with 3% interest to be paid semi-annually on 1 January 2011. Suppose you invest Rs 10,000. The first interest payout will happen on 1 July 2011, since interest is paid semi-annual. During this period, if the inflation is 5%, the inflation-adjusted principal on 1 July 2011 would stand at Rs 10,500 (10,000+10,000X5/100). Hence, the semi-annual interest payment (or real yield) for the bonds would be Rs 157.5 (10,500 x 1.5/100). Alternatively, if you have invested in a regular bond with the same interest rate, you would have got only Rs 150 (10,000 x 1.5/100). If inflation inches further, it would reflected in the principal invested in IIBs, but not in a plain bond.
Needless to say, that makes a huge difference to the return you make.

"Inflation-indexed bonds provide an option for portfolio diversification and would be particularly attractive to individuals with a low risk appetite. In a period of high and volatile inflation, they gain more currency," says Crisil's chief economist DK Joshi. The underlying inflation index reflects the true inflation in the economy for the bonds to work, says Joshi.

"Inflation-indexed bonds are definitely good for a set of investors looking for hedge against inflation. But I feel that acceptance of inflation-indexed bonds will take time," says Nandkumar Surti, chief investment officer, JP Morgan Asset Management. Experts like him think the long tenure of these bonds, lower coupon rate (or the rate of interest offered) and lack of awareness among retail investors may lead to the poor offtake of IIBs and in turn, may result in the government issuing these instruments infrequently.

According to experts, investors must be educated about the benefits of IIBs. For example, the coupon on these bonds is typically lower than that of fixed rate bonds as IIBs are aimed primarily at protecting investors from inflation.
Your inflation shield
However, as you get the interest payout based on the inflation-adjusted principal, your real returns may be higher than other fixed rate bond in higher inflationary times. The only time these bonds will fall out of favour is during deflation - when the principal can be eroded. That shouldn't worry us since we look far away from the deflationary scenario.

Experts also say IIBs can only become popular if they are pushed through retail investors. Also, they believe the tenure of these bonds shouldn't exceed five to 10 years as longer-tenure bonds are not favoured by retail investors, especially senior citizens. "There is no single preferred tenure for these bonds. The appetite for instruments with differing tenure will vary with the type of investor. I think the tenure should extend from medium (five) to long term (10-15) years to cater to diverse needs. I agree with RBI's proposition on this," says Joshi.

The US Treasury Inflation Protected Securities (TIPS) are issued for different maturities and denominations. As of now, you will have to wait to see what the central bank does eventually. The discussion paper says the banking regulator plans to issue IIBs in small lots and based on the experience, may consider expansion in the future.

Curtesy: ET 

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