Inflation-indexation bonds: Not much for retail investors

With the first tranche of inflation-indexation bonds (IIB) going to be on Tuesday, retail investors would be expecting to finally earn positive real returns (above the rate of inflation) from their debt investments.

To encourage retail participation, the Reserve Bank of India (RBI) has also increased the non-competitive portion (read portion earmarked for retail investors) from the existing 5 per cent to 20 per cent.

However, in its present avatar, retail investors will not find much benefit from the first round of IIBs namely the New Inflation Indexed Government Stock 2023.

Reason: This instrument has been designed to beat only the wholesale price index (WPI) – the index that includes prices of food, fuel and manufactured goods.

However, the consumer price index (CPI – for industrial workers) gives the real inflation number that hurts household budgets. And the latter is much stickier in nature.

In 2013, the monthly average WPI has been 6.36 per cent, whereas the CPI at 11.34 per cent is a good 5 per cent more.

In some years, this gap between the CPI and WPI has been exceptionally high. For instance, in 2009, the WPI stood at 2.39 per cent, whereas the CPI was at 10.83 per cent – a difference of 8.44 per cent.

In such circumstances, a WPI-beating instrument would achieve little for the investor because the real returns would continue to be negative. So, despite the hike in the limit, financial experts are not too impressed or recommending this instrument.

Aditi Nayar, economist, ICRA says: “There

will be only partial protection for retail investor from such bonds as it is linked with WPI. The latest reading on new CPI is 9.4 per cent. Even if it eases from this level, there still would be a gap between WPI and CPI.”

What could hurt investors more is that there will be no tax benefit from these products. So, depending on your income tax bracket, the tax could be anywhere between 10-30 per cent on the interest income. That would bring down returns further.

The benefit would accrue to the investor when the bonds mature as debt instrument get inflation indexation benefit. That is, the tax will be 10 per cent without inflation indexation or 20 per cent with inflation indexation.

The good part is that IIBs, which are a revised version of Capital Indexed Bonds introduced in 1997, will provide inflation benefit even to interest income.

So, when the price of the bond goes up due to inflation, the interest will be paid on the adjusted principle.

In other words, if the investment is Rs 10,000, inflation 5 per cent for the year and coupon 3 per cent, the interest will be paid on Rs 10,500.

However, despite these benefits, financial experts believe that since both the inflation (WPI) and interest rates are expected to come down in the next few months, launching these bonds now may not attract too many investors.

Like Investment consultant Gul Tekchandani says, “Given that these bonds are linked to WPI, the name inflation-indexation bond is a misnomer from the word go.”

Recently, RBI executive director R Gandhi said that the bonds could be linked to CPI in the future. It would be a good idea for retail investors to wait for till then.