S Murlidharan

Inflation-indexed bonds, no panacea

S. Murlidharan | Updated on May 13, 2013

These instruments are not very investor-friendly and won't stop the gold rush either.



Inflation-indexed bonds are a complicated financial product that may be beyond the average retail investor’s comprehension, howsoever well-intentioned they might be.

They work somewhat like this: Suppose an Rs 1,000 bond with a three-year maturity is issued at a coupon of 5 per cent. Let’s say that during the first year, the inflation rate has been 5 per cent.

The investor would, then, get an interest of 5.25 per cent. As an icing on the cake, the face value of the bond would stand restated at Rs 1,050, after adjusting for erosion in the buying power of the rupee.

In other words, the investor is protected from the ravages of inflation both on his recurring interest income and the principal amount.

But let’s say that in the second year, the inflation rate climbs to 6 per cent, thereby pushing up the interest rate to 5.57 per cent. The bond’s face value, too, would stand revised to Rs 1,113 to absorb the impact of the higher inflation. And finally in the third year, let us assume the inflation rate rises even further to 7 per cent, warranting an interest payment at the rate of 5.96 per cent and a reset face value of Rs 1,185.

The cumulative financial reward for the investor, thus, works out to Rs 368 on an investment of Rs 1,000. That includes Rs 185 as protection on the principal amount plus interest streams aggregating to another Rs 183 or so.

This is the kind of reward that should make the investor squeal in delight, but correspondingly make the Government bleed. The blow would only somewhat be softened by the time value of money.

Fiscally too heavy

In an inflation-indexed bond, the interest coupon rate necessarily has to be relatively smaller vis-à-vis those on normal bonds that do not provide any hedge against inflation. But to the garden variety investor, any such lower coupon would mean a waning of interest in the bond.

Though she or he might appreciate the significance of protection afforded to the principal amount, what they would still look for and believe is the here and now of it.

And if that interest indeed wanes, the whole exercise would have failed to achieve the original purpose for which the Government has floated these bonds — to wean away people from chasing the yellow metal or putting their savings in land.

To be sure, inflation-indexed bonds may still be lapped up by institutional investors, who have a head for figures and wouldn’t really mind even if the initial coupon is kept as low as, say, 3 per cent in the auction proposed to be conducted.

But then, if these bonds are essentially meant for retail investors, anything less than 5 per cent interest to start with would receive lukewarm response. So, for the Government, this would be only a pyrrhic victory at the end of the day.

The other option, of course, is for the Government to manage inflation itself better to justify lower coupons against the proposed bonds.

That, needless to add, is easier said than done, more so in an election year in which the Government would be tempted to engage in populism, whether it has to do with announcing higher minimum support prices for crops or spending on schemes such as the Food Security Bill.

Thus, with inflation-targeting largely eluding the Government and the retail investor, too, unlikely to settle for low coupon rates, the proposed inflation-indexed bonds are destined for a rough ride.

The talk of tax sops sounds even more ominous. If investments in these bonds carry the sweetener of Section 80C deduction within the existing ceiling of Rs one lakh, there may not be any serious impact on the Government’s finances.

The gold alternative myth

But if a separate tax exemption is carved out for these investments, the scheme would for the Government end up like buying a pig in a poke. And the unfortunate fact here is that the retail investors evince interest only in tax-saving schemes!

At any rate, the assumption that with the introduction of inflation-indexed bonds, people would stop buying gold is not entirely justified given the fact that underlying motives here are not just to hedge against inflation.

Come marriage season, all brides’ families make a beeline for jewellery shops and that’s not going to stop with just introduction of inflation-indexed bonds!

Therefore, instead of ushering in a remedy of dubious efficacy, the Government would do well to persist with discouraging import of gold through stiff hikes in its import duty.

This would, moreover, be a lot simpler than administering and managing an innately uncertain scheme such as inflation-indexed bonds.

Perhaps, it is also time the Gold Deposit Scheme 1999 is revisited. The scheme has been languishing due to extremely low rate of interest — one per cent — and the innate Indian revulsion to melting of one’s own family jewellery.

If the rough edges in the scheme are smoothened, which admittedly would be a tall order, intuitively, a lot of gold inside the country can be recycled, thus obviating the need for imports.

(The author is a New Delhi-based chartered accountant.)

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Published on May 13, 2013
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