It may be worth giving the first inflation-indexed bonds a miss

The more one learns about the government’s inflation-indexed bonds (IIBs), the less it seems like a real effort to give the saver a good deal.

The Reserve Bank of India (RBI) has put out details about how the scheme will work in practice, and the examples given are not particularly exciting.

The first downer is that the real fixed coupon rate may be very low: in the RBI’s example, the figure given is 1.5 percent - which, even if adjusted for a wholesale-price indexed principal, will not give you more than 1.5-2.5 percent yield anytime in the initial years - unless inflation roars suddenly. Of course, the fixed real rate will be determined by bids at the first auction.

The second downer is the tenure of the first IIBs scheduled for subscription on 4 June. This means all through the life of the bonds, you may get measly yields - unless you choose to encash the bonds through a market sale, which will probably reflect in the price. It may be better to wait for short-term tenure bonds.

More from Investing

MSMEs are breaking the traditional convention. Look who’s funding them Scale-up your startup without an investor! Here’s how

The third downer is the WPI base on which inflation indexation will be done. Since the base is the final index number four months before the issue, it could mean January or February 2013 (as of now, it’s not clear which will be used for the June IIB issue). In those months the final WPI numbers were above 7 percent, but the numbers are trending down and currently stand under 5 percent. If the downtrend continues for the rest of the year, the fixed coupon will reflect the expected real rate - the gap between current 10-year bond yields of just over 7.1 percent and the expected trajectory of WPI - say, around 4-5 percent. In the first year, yields may not exceed 2 percent unless bidders seek higher yields in an untested market for IIBs.

[caption id=“attachment_821879” align=“alignleft” width=“380”] IIBs, it seems, have been floated more to dissuade investors from going for gold, which is being restrained not only by higher duties, but by the imposition of artificial curbs. Reuters[/caption]

The fourth downer is the mode of retail participation. As things stand now, RBI says that “retail investors will be able to participate in non-competitive bidding through primary dealers (PDs) and banks. They can open a gilt account with PDs and banks or demat account for such participation.” It is not clear if regular e-trading platforms like ICICI Direct and HDFC Securities can be used or one has to open separate accounts with banks. Till this clarity emerges, retail participants will be rare.

This does not mean the IIBs are duds, but investors need to be clear what they are getting into.

#1: Given current inflation trajectories, initial investors cannot expect decent regular returns. You can’t do a pension plan on IIBs right now. Returns will be more like dividend yields on blue chips - around 1-2 percent. Worse, you have to pay tax on this - unlike dividends.

#2: The real benefit is capital-protection - but this works only over the long-term. But since you have to pay long-term capital gains tax on debt after using the cost inflation index, you may not have full inflation protection for the principal. If the cost-inflation index (CII) and the WPI-based indexation move in tandem, you will be protected from capital gains. But if they differ, and the CII moves slower than the RBI’s IIB index, you could end up paying some tax. You have to pay taxes on the measly coupon rates, too.

#3: At expected level of yields, you could be as well off investing in blue chips such as Infosys, or ICICI Bank, or Reliance, but with the capital risk. Over a 10-year horizon, though, you may be better of investing in index-based funds. One can expect to double the capital over that kind of tenure - but with higher risk.

#4: The IIBs, it seems, have been floated more to dissuade investors from going for gold, which is being restrained not only by higher duties, but by the imposition of artificial curbs. Example: Gold ETDs are now ineligible as collateral.

Net-net, IIBs are not yet a must-have in the portfolio - contrary to what this writer had suggested when they were first announced. They could, though, get better with time. However, there is no reason to think the consumer price-based (CPI) IIBs - scheduled for much later - to be any better.

It may be best to wait and watch. In the meanwhile, continuing to invest a bit in gold and index funds can’t hurt.