A fund launched by Deutsche Bank — DWS Inflation Indexed Bond Fund — offers a simpler option to retail investors who find it cumbersome to invest directly in inflation-indexed bonds.

Ease of investment and liquidity that a mutual fund offers may be positives, but be prepared to take a price risk, as changes in inflation can swing the net asset value (NAV) of the fund in either direction.

Easier entry IIBs provide you a hedge against inflation as both the coupon and the principal are linked to inflation. The principal is adjusted for inflation, and the interest (coupon) is then calculated on the adjusted principal. The IIBs issued initially in June last year, linked to the WPI (wholesale price) inflation, offered 1.44 per cent coupon above the average WPI inflation.

While this set of IIBs was aimed at all categories of investors, retail participation was allowed only up to 20 per cent. There has hardly been any retail participation in these bonds so far. The more recent inflation bond issue is linked to the CPI (consumer price) inflation index, the one impacting your pocket significantly. These bonds are meant exclusively for retail investors. But they have not set the market on fire as they are not available across online platforms and, sometimes, in partner banks to the issue too. The DWS Inflation Indexed Bond offers you a simpler way to investin such bonds.

Liquidity is another plus for investing through the mutual fund route as there is no lock-in period. You can withdraw at any time subject to an exit load of 1.5 per cent for withdrawal within 12 months of investment.

Price risk The fund will invest in inflation-indexed bonds issued by Central, State Governments or corporate issuers.

However, currently institutional investors such as mutual fund houses have access only to bonds which are linked to WPI. So, this fund will essentially invest in WPI-linked bonds. Among corporates, as of now, only Larsen and Toubro has issued inflation-indexed debentures. The fund will invest up to 70 per cent in IIBs and the remaining in other debt securities, including money market instruments. When you invest in IIBs directly, it protects your investment from inflation, by linking the principal and the coupon to inflation.

Also, at the time of redemption, you get inflation-adjusted principal or the original investment, whichever is higher; thus your original investment is safe even if inflation trends lower.

However, in case of the DWS IIB Fund, the fund being a portfolio of these bonds, it will be subject to mark-to-market valuation on a daily basis, and hence there will be volatility in the fund’s NAV. Overall NAV movement will depend on three factors – the change in actual inflation, inflationary expectations over the tenor of the bond and the widening or narrowing of the real spread (interest payable over and above the inflation). Thus, the NAV of the fund can move in either direction based on these factors. As a result, you could see your original investment erode if the NAV declines.

WPI link Besides the price risk, lack of fresh issuances of IIBs and an inactive secondary market may impact the fund performance. According to the RBI’s initial release, IIBs were to be issued every month, with issue sizes in the range of Rs 1,000-2,000 crore. However, so far the issuance volumes have been tepid.

Going by the declining cut-off prices at each of the auctions, there is very little interest from investors. The first sale of the bond was at the coupon rate of 1.44 per cent.

But subsequent issues saw investors demanding a higher coupon of 3.6 per cent. One reason for the lukewarm response from investors is because WPI inflation, which is almost 3 percentage points lower than consumer inflation, is not a true representative of the ‘real’ inflation.

Since it is CPI inflation that impacts you, adjusting the principal and interest for WPI inflation isn’t good enough.

>radhika.merwin@thehindu.co.in

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