Inflation Index Bond.. A hedge against Inflation..?

The Reserve Bank Governor Duvvuri Subbarao today said the central bank is planning to introduce inflation-indexed bonds, under which an investor would get a return on the basis of the prevailing inflation at the time of maturity.

 "One cause of concern is whether in a period of relative high inflation...whether they (inflation-indexed bonds) will be successful. We will think through this... but certainly we will introduce that," Subbarao told a national finance symposium organised by the Indian Institute of Foreign
Trade and the Bombay Chamber of Commerce here.

When bonds are indexed to inflation, the return on them will be linked to the prevailing rate of inflation at maturity of the instrument on both the coupons as well as on the principal repayments at maturity.

The existing bonds are capital-indexed and only protect the capital/principal against inflation, but an IIB (inflation-indexed bond) will be offering investors
inflation-based returns. The index in this case will be based on the monthly wholesale price index.

Pointing out that the past experience with such an instrument was not received well, the Governor said, "we have diversified the instruments for government borrowings now...The zero coupon bonds, capital indexed bonds and now there is a proposal to introduce inflation indexed-bonds.

We tried those inflation indexed bonds earlier, but it did not work out very well but now we want to reintroduce them."

The first capital indexed bond (CIB), known as inflation indexed bonds, was a 2002 Paper, issued on December 29, 1997. But no further issuance was made for want of response from market participants both in the secondary and primary markets.

The RBI formally floated the idea of inflation-indexed bonds when Rakesh Mohan was the deputy governor, though the concept was mooted in the late 1990s.  Later, an RBI technical committee had proposed introduction of fully-inflation indexed bonds for institutional investors with maturities of 10-12 years.

 Under the existing yield norms governing bonds, there is only fixed rate of return and for an issue that was bought when inflation was down does not guarantee higher returns to investor when the inflation goes up.

The CIBs, according to an RBI discussion paper, would help meet the diverse investment and hedging needs of investors and to impart depth to the bond market in general.

The basic feature of IIBs or CIBs is that the coupon is specified in real terms. Such real coupon will be applied to the inflation-adjusted principal to calculate the periodic semi-annual coupon payments.

Unlike the existing capital indexed bonds, which protect only the capital/principal against inflation, the new scheme promises investors inflation-based returns. Under this, if inflation remains high at the time of maturity over the rate when the bond was bought, then the investor will gain, and if it is lower than that rate prevailing at the time of maturity, then the investor will lose out.