But the design should be user-friendly. They ought to be liquid, with interim cash flows, and the tenure should not be long.

One of the major issues plaguing investors and governments all over the world, including India, is high inflation.

To state the obvious, it is leading to negative real (net of inflation) returns on bank deposits and most investments. The economy-wide challenge is being addressed through monetary measures (interest rate hikes by central banks) and fiscal measures (tweak in taxes by the government).

From the perspective of investors, there is another solution: inflation-indexed bonds (IIBs). It helps regulators as well, since it dissuades investments in physical assets like real estate, gold, etc. as people want the assurance of real positive returns.

In IIBs, there is a defined benchmark, i.e., the Consumer Price Index (CPI)-based inflation. There is a mark-up or spread over the benchmark, which is either decided by the government or decided in the initial auction for the issuance of IIBs. This mark-up or spread is the real positive return to the investor, over and above the benchmark. IIBs are there in many countries across the world.

It has been tried in India as well. However, it has not succeeded. Though the idea and intent was good, there were design and execution flaws. Let us look at the IIBs floated in India earlier and the learnings from it, which should help design a better offering next time.

Inflation bonds decoded

IIBs were introduced as `Capital Indexed Bonds’ (CIBs) in 1997. The instrument provided inflation protection only to the principal, and not to the interest payment. It was a nominal coupon rate of 6 percent, not adjusted for inflation.

A Reserve Bank of India (RBI) research paper from 2013 states that, “In developed debt markets, IIBs issued by the government are a popular debt instrument. These governments issue these bonds with an aim to:
(a) Provide a new instrument to investors to hedge against inflation risk.
(b) Enhance credibility of anti-inflationary policies.
(c) Provide an estimate of inflation expectations.

Per the paper, the earlier response was lacklustre because it only hedged the principal against inflation, while the coupon was left unprotected, and there were complexities involved in the pricing of the instrument.

IIB 2013: a flop show

In 2013, a Wholesale Price Index (WPI)-linked IIB was launched. It paid a real coupon of 1.44 percent on the adjusted principal, and the principal was adjusted to WPI. On maturity, the adjusted principal was paid back. It was a government of India bond with a 10-year maturity.

There was no tax benefit. The drawback of this product was that it was based on the WPI, and soon after, the RBI transitioned to the CPI for policy formulation. At 10 years, the tenure was on the longer side; people react to inflation more with shorter horizons. Accessibility and liquidity — required to make it a success for retail investors — were both question marks.

Towards the end of 2013, the RBI announced the Inflation Indexed National Saving Securities-Cumulative (IINSS-C). The reference index was the CPI. There was a cap of Rs 5 lakh per investor per year. Designed as a retail product, individuals and Hindu Undivided Families (HUF), were eligible, not corporates. The tenure was 10 years and there was no interim cash flow.
The interest rate comprised two parts. There was a fixed rate of 1.5 percent, and an inflation rate based on the CPI which was compounded every six months and paid on maturity. There were no tax benefits.

Hence its only appeal was a real return of 1.5 percent over CPI , and sovereign credit quality. However, here too, liquidity was an issue: once invested, your money was locked away for 10 years. It was not attractive for HNIs due to the cap of Rs 5 lakh per year. There was no interim cash flow either.

The way forward: what can the RBI do?

There is both a need and scope for IIBs.

It’s a win-win. It helps address investor concerns over high inflation, and signals the sincerity of the authorities in containing inflation. However, the product should be designed such that it is user-friendly. For retail investors, it should be accessible, liquid, have interim cash flows (coupon pay-outs), and the tenure should not be too long.

It could be made available on the RBI Retail Direct Gilt (RDG) platform, as also through banks and post offices, in both digital and physical form. Mutual funds, among others, should be allowed to invest in IIBs to grow its market and enhance chances of its success.

Source: https://www.moneycontrol.com/news/business/personal-finance/why-investors-need-inflation-indexed-bonds-9050881.html