VR Logo

Inflation Indexed Bonds are a Disappointment

The RBI announces the inflation-linked bonds that the FM promised in the budget, but they won’t be any use

Value Research Stock Advisor has just released a new stock recommendation. You can click here to learn more about this premium service, and get immediate access to the live recommendations, plus new ones as soon as they are issued.

The government has made an announcement regarding the launch of the inflation-indexed bonds that Finance Minister P. Chidambaram had first promised in his budget speech. However, there is complete discordance between what Mr. Chidambaram had said in his budget speech and what the RBI has now launched. Here’s what the budget speech said: ...in consultation with RBI, I propose to introduce instruments that will protect savings from inflation, especially the savings of the poor and middle classes. These could be Inflation Indexed Bonds or Inflation Indexed National Security Certificates. The structure and tenor of the instruments will be announced in due course.

Now, the RBI has announced these bonds that, while paying lip service to above sentiment, appear to just another part of the government’s borrowing program. Here’s what the central bank says: Pursuant to the announcement made in the Union Budget for 2013-14 to introduce instruments that will protect savings of poor and middle classes from inflation and incentivise household sector to save in financial instruments rather than buy gold, RBI, in consultation with Government of India, has decided to launch Inflation Indexed Bonds.

After reading these noble thoughts about saving the poor from the vagaries of inflation, any reasonable person would expect that the bonds would, a) be linked to the consumer price inflation index; and b) be available to retail customers (and retail customers alone) in a simple manner, perhaps through bank branches and post offices.

Nothing of the sort. Firstly, the bonds are linked to the Wholesale Price Index. This in itself makes a joke out of all these pious statements about saving the poor and the middle-class from inflation. According to the government’s own latest data, wholesale inflation is 4.89 per cent and consumer inflation is 9.39 per cent. By launching inflation-linked bonds that are keyed to the former instead of the latter, the government is not saving the poor from inflation, but is actually saving itself from inflation by robbing the poor. Effectively, it is borrowing from the said poor and the middle-class and underpaying them by something like four to five percentage points.

However, have no fear that this will actually happen. The RBI’s press release makes it clear that these bonds are not actually meant for the masses. Right now, it will sell these bonds through the normal institutional channels as it does with the rest of the government’s bond issuance. The release says that “For appropriate price discovery and market development, it is however, necessary to issue comparable instruments through auctions to the institutional investors such as Pension Funds, Insurance, and Mutual Funds etc. This will create demand for IIBs and help in making them tradable in the secondary market.”

Translated, this means that the RBI is trying to test how much of rate it will have to pay above the WPI. Essentially, these are just another type floating rate bond. Instead of being explicitly linked to a benchmark interest rate, they are linked to the rate through the proxy of the Wholesale Price Index. In this first issuance, the RBI is trying to discover how the bond market treats this proxy link in setting the value of these bonds. If one takes the RBI’s statement at its word, then at some point a version of these bonds will be launched for the public which will have an interest rate payable at whatever rate gets discovered through the price at which institutions will buy and sell these bonds.

Unfortunately, all this is irrelevant to the originally stated purpose of these bonds. A large proportion of India’s savers are interested only in fixed-income instruments. The original problem was that these give returns that are far below the inflation rate that the savers face in their lives. If anyone thought that solving that problem was the goal, then these bonds are an eyewash. For savers, the inflation problem stays where it was.