The security and comfort associated with assured return schemes comes at a price -- inflation!
Inflation in simple terms means a rise in the general price levels or cost of living. Inflation eats into the returns offered by assured return schemes like fixed deposits and small savings schemes, thereby leaving investors with dismal real returns.
Let's take an example to better understand this, say you are invested in a fixed deposit which offers you a return of 6.25% per annum. Assuming an inflation rate of 5.00%, your net returns are just 1.25% per annum (6.25% less 5.00%). The tax liability on the interest income further diminishes the attractiveness of such instruments.
So how should investors beat the inflation blues? Though equities are known to be the asset class best equipped to beat inflation, they may not suit the risk appetite of all investor classes. Broadly speaking, fixed income instruments have been the domain of investors with a low risk appetite, and such investors may be averse to the idea of investing in equities.
The solution may lie in the Capital Indexed Bonds which the Reserve Bank of India (in consultation with Government of India) proposes to introduce.
Key features of the proposed Capital Indexed Bonds:
Offer inflation-linked returns on both the coupon rate (interest rate offered by the instrument) and principal repayments as well. This would be achieved by adjusting the principal amount in tune with changing inflation rate.
Interest payments would be computed at a fixed rate on the adjusted principal amount. For example: say, the CIB is issued at Rs 100 on June 1, 2004 with a fixed coupon of 3.00%. Six months henceforth when the first interest payment is due, the principal amount will be recalculated based on the existing inflation levels. The same CIB worth Rs 100 bond could now be worth Rs 110 on account of the rising prices, the coupon rate will be applied to this revised sum and interest payments made accordingly.
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This method of revising the principal amount will be repeated for each subsequent interest payment and the principal repayment as well. A decline in inflation levels would imply a lower principal sum for investors; however the downside on the principal repayment has been protected.
It has been proposed that on maturity the principal amount will be repaid at original face value or at an inflation-adjusted figure whichever is higher.
For the investors the Capital Indexed Bonds promise to be a double bonanza, they purport to offer returns at a fixed rate and yet incorporate the ability to combat inflation. The bonds would carry the highest degree of safety since they are issued by the central bank. This is definitely one product to look forward to.
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