The first series of the much awaited Inflation Indexed Bonds (IIBs) were issued on Tuesday, with a coupon rate set at 1.44 per cent.
Of the total issue size (Rs 12,000-15,000 crore) planned in 2013-14, the first auction held raised Rs 1,000 crore.
The participation from institutions was 80 per cent, with 20 per cent set aside as ‘non-competitive’ bid for retail investors.
The maiden IIB issue was fully subscribed.
This is despite investor interest prior to the issue being lukewarm due to the recent decline in WPI inflation numbers.
Do these bonds make a good investment at the current coupon rate?
Returns, sensitivity
Let us assume that WPI falls to five per cent next year and stays at that level over the next decade.
At the current coupon rate, an investor in the 20 per cent tax bracket who invests Rs 100 now would be left with Rs 163 after the 10-year period.
The gains are taxed as long term capital gains (20 per cent with indexation or 10 per cent without).
The interest after re-investment and 20 per cent tax works out to Rs 14.6, giving a total value of Rs 177.6.
To compare the returns, we assume bank fixed deposit rates are stable at 8 per cent. After paying taxes at 20 per cent rate, a depositor who made a Rs 100 investment will have Rs 186 after 10 years. The higher bank deposit rate and the low WPI make IIB unattractive.
When IIB scores
That said IIBs are a better bet for investors in the higher tax bracket and they also give superior returns when the WPI is rising.
Given that the gain in the principal of IIB is taxed under capital gains tax, these instruments offer better returns for an investor in the 30 per cent tax bracket.
In this case, an FD investor gets Rs 172 while an IIB investor would be left with Rs 173.2. A lower coupon rate does not impact returns, due to the tax effect. Similarly, if we assume that the WPI stays at 6 per cent for the first five years and rises to eight per cent in the next five years, the final amount increases to Rs 213.3. A fall in WPI to four per cent in the last five years of the 10-year tenure leaves the investor with Rs 178.4. An IIB investor may be able to earn a higher return when inflation increases, even if the deposit rates do not keep up.