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.

A Cashless World Or World With Virtual Cash?

Money is what money does! OK, it may be carrying things a bit far. But money does have some definition. As per Wikipedia, money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country.

Money does have many functions and they are to serve as (i) a medium of exchange; (ii) a unit of account; (iii) a store of value; and (iv) a standard of deferred payment.

Now we are clear about what money does. But what are the characteristics of money? They are: (i) durability, (ii) divisibility, (iii) portability, (iv) non-counterfeit-ability and (v) consistency.

All contemporary money systems are based on fiat money.  Fiat money is without intrinsic use value as a physical commodity. It derives its value by being declared by a government to be legal tender; that is, it must be accepted as a form of payment within the boundaries of the country, for “all debts, public and private”. Such laws in practice cause fiat money to acquire the value of any of the goods and services that it may be traded for within the nation that issues it.

Now we have seen what money does and what are its characteristics. You must have observed one interesting point here – there is no requirement that money or cash should be physical object! This gives rise to interesting possibilities.

Two recent developments are worth mentioning when we talk about money. The first one is the news report that Swedish banks are doing away with cash as Krona goes virtual and second one is emergence of Bitcoins.

Let us look at the first development. A report on Bloomberg on 11th April 2013 said that most of big banks in Sweden have stopped manual cash handling services in 65 percent to 75 percent of their local branches! They say cash is out as Swedes rely on credit cards, the Internet and mobile phones to make all their payments! Currency is used in only about 20% of shop transactions! Further, these banks say that only 5 percent of their clients make over-the-counter cash transactions. Here it is to be noted that the Nordic countries did away with the cheque about thirty years ago!

Swedish banks say that removing cash handling services is helping them to cut costs. It is also helping in raising income from their cards business! Removal of cash handling services have also helped in drastically reducing bank robberies in Sweden!

Incidentally banks in Sweden have performed better than many banks in rest of Europe! These banks are also among Europe’s best capitalized banks.

The second development is the excitement caused by Bitcoins. They’re a virtual currency invented in 2009 by a mysterious hacker who adopted the pseudonym Satoshi Nakamoto. Angered by the 2008 financial crash, Nakamoto wanted to create a currency that would be independent of government, so that a person’s money could be secure from the machinations of politicians and bankers. The Bitcoins themselves are all bit and no coin — there’s nothing solid to hold in your hand, just a series of letters and numbers that you keep in a virtual “wallet.” Once you have them, you can exchange them online for actual goods! Unlike U.S. dollars, euros, or other established currencies, Bitcoins are not backed by any  government or central bank. With Bitcoins, the transactions are purely peer-to-peer, but the movement of every single Bitcoin is tracked and publicly recorded to avoid fraud and counterfeiting.

One can “mine” them by using highly sophisticated computers to compete against others to solve complex math problems and win the Bitcoins, released every 10 minutes in a sort of lottery. So far, around 11 million have been mined, and the lottery will stop when 21 million Bitcoins have been generated. A much simpler way to get your hands on a Bitcoin is to just buy one from someone who already has them — usually on a currency exchange website that allows you to swap dollars for Bitcoins. Then when you want to spend the Bitcoin, you send the agreed-on amount to the recipient’s online “wallet,” and off it goes.

Bitcoins do perform the functions which fiat money does i.e., to serve as (i) a medium of exchange; (ii) a unit of account; (iii) a store of value; and (iv) a standard of deferred payment. Further, it also has characteristics of fiat money  i.e.,  (i) durability, (ii) divisibility, (iii) portability, (iv) non-counterfeit-ability and (v) consistency.

What is does not have is legal backing and a central bank. Recently, Bitcoin’s value plummeted 77 percent in just two days, due to technical problems with a Bitcoin exchange server, and it has experienced similar crashes in the past when servers or virtual wallets have been hacked. That volatility limits Bitcoins’ appeal: How can people depend on a currency whose value can halve from one day to the next?

There are also deeper problems over its legality. It’s only a matter of time before officials address two major issues: First, the fact that the Bitcoin effectively competes with the fiat currency, thereby violating law. Second, that because Bitcoin transactions are anonymous, criminals and money launderers see huge opportunity!

Now let us come to the very purpose of this article –  Will virtual currency make paper currency redundant? Will virtual currency become more acceptable than fiat currency?

The most important requirement for a medium of exchange is acceptability. It is very difficult to see wide acceptance for any currency without legal backing and a regulator. However, use of cards, the Internet and mobile phones can increasingly do away with the paper currency but it is a bit difficult to visualize a future with a dominant virtual currency without any legal backing such as Bitcoins.

Bitcoins may be useful for making online payments for small value purchases on the internet but large ticket deals and investments in Bitcoins (or some other similar currency) is something which is very difficult to visualize now!

I will place my bets on a cashless world than on world with virtual cash!