3 reasons why inflation-indexed bonds have failed to attract investors

The Reserve Bank of India is worried about the muted response it has received on inflation indexed bonds which it launched with lots of fanfare as the weapon to fight inflation as far as retail investors are concerned.

This worry comes from many factors. First of all, it seems that small investors have failed to buy the logic of inflation beating capability of these bonds despite the bonds being topped by consumer price index (CPI) with a base return of 1.5%. This means that whatever be the rate of inflation as represented by CPI, investors will get an additional return of 1.5% over and above inflation which is subject to a semi-annual compounding.

Secondly, worry comes from the fact that investors may still continue to prefer investments in physical assets which will defeat the purpose of issuing these bonds.

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[caption id=“attachment_79329” align=“alignleft” width=“380”]  If inflation falls why would you want to invest in these bonds? AFP[/caption]

The RBI has decided to step up measures to promote these bonds by providing an additional incentive at the rate of 0.5 percent on the amount collected by agency banks (including Stock Holding Corporation of India) that garner subscriptions of Rs 100 crores or more by March 31.

This is over and above 1% incentive being given as of now. This is indeed highly attractive proposition to push any product in the market. So why is it that the RBI has to incentivise a bond which small investors in the US sometimes buy even at negative yield during auction of similar bonds called treasury inflation protected security or TIPS?

The reasons for poor response to these bonds are many which can be described as follows:

RBI is contradicting itself on inflation indexed bonds: While on the one hand the RBI talks about bringing down CPI levels as per the Urjit Patel Committee report recommendations, on the other it expects investors to buy these bonds where returns are based on movement of the CPI inflation.

Today an investor has an option to lock his money for 10 years at a rate of around 9 percent on tax-free bonds which will remain same for ten years. On the other hand, inflation-indexed bonds will fetch lower returns for investors as the RBI works on implementation of the Patel Committee report recommendation.

The committee has recommended that inflation should be brought down from current level of 10 percent to 8 percent over a period not exceeding the next 12 months and to 6 percent over a period not exceeding the next 24 month period before formally adopting the recommended target of 4 percent inflation with a band of +/- 2 percent.

Now, suppose the RBI manages to achieve its inflation target in 2 years, it will render the inflation indexed bonds unattractive. Why would an investor lock in for a return of approximately 7.5 percent on these bonds when he can get a return of 9 percent on tax-free bonds? It is true that he will continue to beat inflation using inflation index bonds, but the returns won’t be the best for him.

Contrary to RBI claims these bonds are not risk free: The RBI has been advertising that inflation indexed bonds as risk free bonds. It is true that these bonds do not have default risk (assuming that the government can print currency and honour its commitment), but these bonds do carry an element of risk which Indian investors abhor. These bonds don’t offer a fixed rate of return as they are benchmarked to a rate of inflation.

Returns from these bonds will vary with the rate of inflation. Indian investors always prefer stable cash flows arising from a bank deposit or NSC or tax-free bonds rather than opting for a variable return product. The so-called risk-free feature of these bonds is restricted to default risk or in some way the ability of these bonds to beat inflation but the risk is not all together removed as returns remain variable.

Taxability of these bonds is a big dampener for the investors: Inflation indexed bonds do not enjoy tax benefit the way some of the other debt investment products enjoy. For investors in 20 percent and 30 percent tax bracket, these bonds are not much attractive as the interest earned is subject to taxation which makes post-tax return from these bonds as unattractive compared with some of the other investment products such as PPF or tax-free bonds.

In order to enjoy, high post-tax return from these bonds, the investors in the 20 percent and 30 percent tax bracket should always pray that inflation rates remain on the higher side which is against the basic premise on which the RBI has been formulating its monetary policy in the recent years. Though the RBI cannot do much to make these bonds as tax free, it can impress upon the government to consider making these bonds as tax free.

The author is a financial planner and columnist.