Inflation indexed bonds on 4 June: Here's what you need to know

The Reserve Bank of India plans to issue inflation-indexed bonds in phases to discourage investments in gold, with the first tranche of bonds worth Rs 1,000-2000 crore being issued on June 4 for a total of Rs 12000-15000 croreby the fiscal year ending in March 2014.

The principal will be indexed to the wholesale price index with a four-months lag, while the coupon will remain fixed, the central bank said.

The RBI will aim to eventually sell these bonds to retail investors around October, after gathering experience about the coupon rates from the initial sales.

These bonds will be issued as part of the government’s borrowing and it will also be issued to small savers as an alternative to the National Savings Certificate (NSC).

IIBs were first issued in 1997 only to be discontinued later. The 1997 IIB issuance was in the form of Capital Index Bond (CIB), where only the principal repayment was indexed to inflation. The current CIB version of IIBs will protect interest payment as well as principal repayment from inflation.

Which inflation?

Inflation for the purpose of IIBs will be the wholesale price index (WPI) with base year 2004-05. The WPI used for calculating the index ratio, which is the inflation rate for the purpose of indexing, will be the final WPI. The final WPI is released after a lag of two-and-half months from the date of first release. For the purpose of calculating the index ratio, two consecutive final WPIs are required. Hence WPI used for calculating the index ratio will be four months old. For example, if the index ratio is being calculated in August, WPI for months of April and May will be the reference inflation index.

How do IIBs work?

IIBs have a par value, tenor and interest rate. The interest payment and par value will reflect the rise or fall in inflation. Let us take an example.

IIB is issued on 8 March 2012 at a par value of Rs 100 for a maturity period of ten years and carrying an annual interest rate of 5 percent. The WPI for the purpose of fixing the interest rate on the IIB is a WPI index level of 100.

The first interest payment on the IIB is due on 8 March 2013. What will the IIB holder receives as interest payment? The reference WPI on 15 March is 107.5. Inflation was 7.5 percent over a one-year period. How will the IIB holder be compensated for the rise in inflation?

The first step for calculating the interest payment is to calculate the index ratio.

Index Ratio = Reference WPI on the interest payment date / Reference WPI on the issue date.

Reference WPI on Interest Payment Date = 107.5

Index Ratio= 107.5/100 = 1.075

Par value of the IIB on issue date= Rs 100

Par Value of IIB on Interest Payment Date = Par Value of IIB on Issue Date * Index Ratio = Rs 100* 1.075= Rs 107.5

Interest rate on the IIB = 5 percent

Interest payment the IIB holder receives on 8 March 2013 = 5%* Rs 107.5= Rs 5.375.

The IIB holder is thus compensated for the rise in inflation through higher interest payout.

The rise in par value of the IIB adjusted for inflation compensates the principal of the IIB holder against inflation.

The problems

The issues on IIB in India would be

1. The relevance of WPI as the reference index, given the structural issues surrounding the index in terms of data collection, components etc.

2. Lack of real yield curve hampers the price discovery of IIBs and might lead to incorrect fixing of yields at the time of issuance.

3. Liquidity could be low if market has doubts on its inflation forecasting ability.

4.The wide gap between WPI and Consumer Price Index, which is currently at around 3.5 percent leads to doubts on the IIB holder being compensated for true inflation in the economy.

5.Change in WPI components and base years will affect IIB holders.

The RBI’s publication on Inflation Indexed Bonds dated 9 December 2010 gives out the form of the IIBs that would be issued in India. The central bank has discussed the modalities of issuance of IIBs by the government as part of its borrowing programme and has gone into more technical details of bidding for IIB auctions, settlement price of IIBs, rounding off the Index Ratio etc.

The structure of IIBs for small savers has not been put out but the principal of the IIB will be as per the RBI’s publication.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.