The Hindu Business Line : On capital-indexed bonds

If you had not invested in the bond, you may have used that money to buy, say, a TV set. So, you have postponed this consumption to invest in the bond. Suppose you decide to buy the TV set at the end of the year with the money that you receive from the bond investment.

What if the price of the TV set increases by 7 per cent? You will have to pay 7 per cent more for postponing consumption but you receive only 5 per cent as interest from your investment. The increase in price level has reduced your ability to buy the TV set. To use a jargon, your purchasing power has been eroded.

But what if you have a product that will protect you from inflation or the rise in price level? The capital indexed bond is one such product. The instrument will initially carry a face value of Rs 100. Instead of offering a nominal rate, the instrument will offer a real rate of interest.

Real interest rate is nothing but the nominal interest rate less the inflation. If inflation increases by 10 per cent, the face value of the bond will also increase by 10 per cent to Rs 110.

You will receive a real interest rate on Rs 110. The increase in the bond's principal amount protects your purchasing power. In the developed markets, these instruments are also called as inflation-protection securities.

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