The Hindu Business Line : Return of the capital indexed bonds

THE Reserve Bank of India proposes to re-introduce capital indexed bonds. These bonds are inflation-protection securities. Such bonds, therefore, provide good hedge against inflation risk. The benefits do extend beyond hedging. Capital index bonds can be used as a market indicator for inflation expectation. This will help investors take a more intelligent decision on their current consumption. Finally, the spot yield curve can be better constructed based on the real yields.

Inflation risk: A nominal bond is exposed to high inflation risk. This is the risk that inflation will increase, leading to increase in interest rate. Essentially then, inflation risk is a sub-component of interest rate risk. A capital indexed bonds lowers the interest rate risk by neutralising the inflation risk.

Suppose the face value of the capital indexed bond is Rs 100 and the real interest rate is 3 per cent. If on the reset date, inflation rises by 5 per cent, the face value of the bond will rise to Rs 105. Bondholders receive real interest of 3 per cent on the indexed face value. This neutralises the inflation risk and protects the investors' purchasing power.

The effectiveness of the hedge will, however, depend on the appropriateness of the inflation index. The purpose of issuing capital indexed bonds will not be fully served if the RBI were to use the Wholesale Price Index (WPI) or the Retail Price Index (RPI) as the index for inflation. The reason is that these indices do not adequately capture inflation as it affects the investors, especially the retail class. Perhaps, the RBI should consider a basket of goods based on the current consumption of the common man.

A point may be raised here that banks and primary dealers are the major investors in government bonds. So, why then should inflation index represent the retail consumption and not the WPI?

The reason is that all money flows can be eventually traced to the common man. Banks, for instance, invest in government bonds with the deposits they receive from retail investors.

If banks are protected against inflation risk, they may, perhaps, pass on the benefits in the form of higher interest rate to the retail investors. That, in turn, provides retail investors a higher cushion against inflation risk. In such cases, more the inflation index is aligned to price levels affecting retail consumption, better the hedge.

Inflation expectation: Investors buy bonds by postponing their current consumption. There is, therefore, a trade-off between investment and consumption. To make an intelligent decision between these two states of nature, investors need an indicator to measure inflation expectations. At present, due to lack of adequate measures, we assume that inflation expectation is the same as current inflation. If actual inflation were higher in the future, the investment decision may be unattractive. It is, therefore, important to proxy inflation expectation. A capital indexed bond helps in this regard.

If the RBI were to issue capital indexed bonds across the yield curve, we will have real yields for each maturity sector. We already have nominal yields as well for these sectors. The difference between the nominal and the real yields is a proxy for inflation expectation. Suppose the nominal yield for a five-year bond is 5.75 per cent whereas the real yield is 3 per cent, we can assume that the inflation five years hence will be 2.75 per cent.

An argument may be that this difference may contain noise because daily yields are governed more by demand and supply for bonds. True, but demand-supply is a function of the market's expectation of future inflation.

Besides, sophisticated statistical models can back out such noise. Investors can, therefore, have a better proxy for future inflation. This will lead to more intelligent current consumption. Importantly, demand and supply for goods and services in the market would not be driven by irrational inflation expectations. This could lead to more balanced conditions in the market, leading to a positive feedback on current inflation.

Finally, a spot yield curve that backs out noise due to inflation may be more helpful for bond investors. Moreover, the RBI also proposes to introduce STRIPs. Such instruments will make more sense on real interest-bearing bonds than the nominal ones.

(Feedback can be sent to bvenky@thehindu.co.in)

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