Long Term Investments and Inflation Indexed Bonds

Inflation is one of the biggest worries for investors, especially for those who need to invest for a longer term (say 10 years or more) to provide for their retirement and old age.

Imagine redeeming your bank deposit with accumulated interest after 10 years and then finding that the proceeds cannot even buy half the amount of goods and services that the principal amount would have bought 10 years back! Thus, a depositor will have to face a lot of uncertainty on real value of his savings. Therefore, there is a need for instruments which will not only provide return on investment but will also protect the value of the principal against inflation.

Inflation Indexed Bonds are ideal instruments under these circumstances. An Inflation Indexed Bond (IIB) protects investors from the uncertainty of inflation over the life of the bond. while IIBs are similar to conventional bonds in payment of interest at fixed intervals and return the principal at maturity, the fundamental difference is that unlike conventional bonds which make payments at the contracted nominal rate, IIBs make payments that are fixed in real terms (and thus are called real bonds). The interest payment and return of principal of IIBs are adjusted for changes in the rate of inflation from the date of deposit till when these payments become due.

The primary benefit to investors of long-term IIBs is that they would give investors a long-term asset with a fixed long-term real yield that is free from inflation risk.

Historically, investors in long-term conventional bonds or bank deposits have been exposed to substantial inflation risk. In 1955, for example, the US Treasury issued a 40-year bond with a coupon rate of 3 percent. Because the actual inflation rate over the past 40 years was 4.4 percent, an investor who bought this bond at full price and held it to maturity received a negative 1.4 percent yield on this investment ( i.e., 3& – 4.4% = -1.4%).

In this context, the IIBs which Reserve Bank of India proposes to issue might be a good alternative to bank deposits for long term retail investors. Consider these aspects (from RBI Notification):

  1. IIBs of RBI will be having a fixed real coupon rate and a nominal principal value that is adjusted against inflation. Periodic coupon payments are paid on adjusted principal. Thus these bonds provide inflation protection to both principal and coupon payment. At maturity, the adjusted principal or the face value, whichever is higher, will be paid.
  2. Index ratio (IR) will be computed by dividing reference index for the settlement date by reference index for issue date (i.e., IR set date = Ref. Inflation Index Set Date / Ref Inflation Index Issue Date).
  3. Final Wholesale Price Inflation (WPI) will be used for providing inflation protection in this product. In case of revision in the base year for WPI series, base splicing method would be used to construct a consistent series for indexation.
  4. Indexation Lag: Final WPI with four months lag will be used, i.e. Sept 2012 and Oct 2012 final WPI will be used as reference WPI for 1st Feb 2013 and 1st March 2013, respectively. The reference WPI for dates between 1st Feb and 1st March 2013 will be computed through interpolation.
  5. Issuance method: These bonds will be issued by auction method.
  6. Retail Participation: Non-competitive portion will be increased from extant 5 per cent to up to 20 per cent of the notified amount in order to encourage participation of retail and other eligible investors.
  7. Maturity: Issuance would target various points of the maturity curve in order to have benchmarks. To begin with, these bonds will be issued for tenor of 10 years.
  8. Issuance Size: Each tranche of IIBs will be for `1,000 – 2000 crore and total issuance would be for about `12,000-15,000 crore in 2013-14.
  9. Issuance Date: First such tranche will be issued on June 4th 2013 and the same would be issued regularly through auctions on the last Tuesday of each subsequent month during 2013-14.

RBI says that Second series of IIBs will exclusively be for retail investors and will be issued in second half of the financial year 2013-14.

First series of the IIBs will help in determining the coupon rate for the bonds through auction. This will help in benchmarking IIBs. Based on the experience in the initial issuances, second series of IIBs for the retail investors is proposed to be issued around October 2013. RBI says that terms of issuance of IIBs for retail investors would be announced in due course.

So we need to wait for auctions in June 2013 to have an indication on copoun (interest) rates for these bonds.

Added on 21st June 2013:

On 4th June 2013 the Reserve Bank of India sold 10 billion rupees worth of 10-year bonds at a real yield of 1.44 percent over the wholesale price index.

The Reserve Bank of India (RBI) will conduct the second tranche of inflation indexed bonds (IIBs) auction for Rs 1,000 crore on June 25, 2013. These bonds of 10-year tenure (2023) will carry a real yield of 1.44 percent. With a real yield at 1.44 percent, the coupon rate will be around 8.28 percent. Those bonds are linked to the wholesale price index (WPI) based calculations. RBI had earlier mentioned that the monthly final WPI would be used with a lag of four months. Hence, this auction rate is connected to February WPI which was at 6.84 percent.