BOND WATCH. How have inflation-indexed bonds fared?

Remember inflation-indexed bonds, which were launched with a lot of fanfare by the RBI two years ago? With inflation ruling high at that point in time, these bonds were deemed must-haves in a retail investor’s portfolio. Finally, there was an instrument that could offer inflation-beating returns and carrying minimal risk, unlike equities.

That was then. Now, with inflation moving southward, returns on these bonds have been lower than those offered by bank deposits. If you’ve invested in these bonds, here is what you need to take note of.

Inflation-indexed bonds were designed to provide a hedge against rising prices or inflation. The first set of bonds provided a fixed return over and above WPI inflation and the second used CPI as the reference rate to calculate returns. Since the latter captured the true inflation at the consumers’ end, it found more takers than the former.

Let us consider CPI inflation bonds first. These bonds were named Inflation Indexed National Savings Securities - Cumulative. With a minimum investment of ₹5,000, they were made available only to retail investors. Interest, which was taxable, was calculated as the sum of the Consumer Price Inflation (CPI) rate and a fixed rate of 1.5 per cent annually. The CPI rate was considered with a three-month lag — for instance, for December 2015, combined CPI for September 2015 will be used as the reference rate. The interest is not paid out, but compounded half yearly. On maturity, which is 10 years from investment, the investor gets back the principal along with the accumulated interest.

Hence, if the CPI inflation is 9 per cent for six months, then add to this 0.75 per cent (half of 1.5 per cent) and the interest paid will be 9.75 per cent. So, if you invested ₹5,000 in December 2013 (when the bonds were launched), then by June 2014, your investment will be worth about ₹5,487.

Given that long-term deposits then offered a little over 9 per cent, these bonds seemed to offer a good deal for investors.

But with inflation falling over the last two years, returns which were earlier calculated based on expectations of a rise in inflation, have gone awry. In fact, the return on these bonds is now lower than of bank deposits.

When the bonds were launched, the RBI stated that the combined Consumer Price Index [(CPI) Base: 2010 = 100] would be used to calculate returns. But as a new CPI series has been flagged off this year (base year 2012), we have considered the new CPI for our workings.

If you had invested ₹5,000 at the launch of these bonds, then your investments would be worth about ₹5,700 as of this December. The annual return works out to about 6.5-7 per cent. Despite the recent cut in deposit rates, long-term bank deposits still offer about 8 per cent.

Let us now consider WPI-linked inflation-indexed bonds. The coupon rate (over and above the WPI inflation) was determined through an auction. Initially, this rate was fixed at 1.44 per cent, which remains constant for the tenure of the bond (10 years). Interest is paid half-yearly. Inflation is accounted for through adjustments to the principal amount. These bonds, unlike the CPI-linked bonds, are traded in the market, albeit with very thin liquidity.

With WPI inflation sliding into negative territory, these bonds have dipped below face value and now trade at ₹83-84 versus the original investment of ₹100.

These bonds, when auctioned, did not see much retail participation. But investors had the option of investing in them indirectly through the mutual fund route.

Three fund houses had launched funds that predominantly invested in inflation-indexed bonds (WPI linked) — DWS Inflation Indexed Bond Fund, HDFC Inflation Indexed Bond Fund and SBI Inflation Indexed Bond Fund.

These funds score well on liquidity. Investing directly in inflation bonds (WPI and CPI) would have meant a 10-year lock-in. Also, while your interest on inflation bonds is taxable, in case of funds, you get indexation benefits on capital gains if you hold them for three years. With the returns from these bonds dipping with inflation, the funds have delivered low returns too.

Hence, inflation-indexed bond funds have delivered a muted 3-3.5 per cent return in the last one year.

If you invested in inflation-indexed bonds directly or indirectly through the mutual fund route, what should you do now?

Despite the recent poor returns, you should not exit these bonds in a hurry. One, you bought these bonds to protect against inflation and they are doing a good job of that. If inflation does pick up again over the long run, the returns from these bonds would certainly perk up.

Two, early redemption options on the bonds are not attractive. In the case of CPI inflation bonds, as they are not listed, early redemption will cost you half the last payable coupon. In any case, premature redemption is allowed only after one year for investors above 65 years, and after three years for others. In case of the debt mutual funds, yes, early exit is possible, but will be tax inefficient. You need to hold on for three years to benefit from indexation.

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