The government has attempted to issue IIBs several times in the past but to no avail. However, with Rajan coming in, that might change
25-Sep-2013 •Anand Tandon
The RBI witnessed a change of guard on the September 4, with Dr Raghuram Rajan taking over as the new Governor. His first statement as Governor outlined a time-bound policy program that enthused markets immensely. For the average retail investor though, the relevant point of interest was a mention that a new series of Inflation indexed government securities would now be issued--which would be linked to the Consumer Price Index (CPI) rather than WPI (wholesale price index).
This is indeed a big difference. In the past, the government has attempted to issue inflation indexed bonds (IIBs) several times but not met with success. Even the issuance earlier this year, while ostensibly a success, did not excite retail participants. After all, households are interested in insulating themselves against inflation as they see it-not as the government would like them to see it. The pedantic argument that WPI is computed more often than other inflation indices is not likely to cut ice with any investor who is receiving a return based on a number which is roughly half of what he actually experiences.
The mechanics of IIBs
In a normal bond, investors take a risk on inflation and interest rates. For example, investors have no incentive to buy a government security yielding say 8 per cent today, with CPI at 9 per cent. The investor has no incentive to save. Additionally, if inflation were to rise to say 9.5 per cent, the saver would be further penalised. This behaviour forces investors to seek higher yields in real assets--gold and real estate--as we have indeed witnessed over the past few years.
IIBs offer an investor a “real” return on investment. The bond is initially issued with a face value of say Rs 100. The coupon rate would be a “real rate”, say 2 per cent. If the CPI for the quarter is 9 per cent annualised as in the example above, the interest rate of 2 per cent would be computed on Rs 102.25 i.e. Rs (100 + 0.25 * 9%). The face value at the quarter end would now stand at Rs 102.25. In other words, the inflation is factored into the principal, while the interest is paid on the enhanced principal.
The long-term investor does not need to worry about the direction of inflation--since the position is hedged. Interestingly, it is possible that if inflation falls below zero (yes, it can), i.e. price levels start to fall, the bond principal would be adjusted downwards. In theory, it is possible that the bond may not repay the entire principal on maturity--if negative inflation persists. However, in India this is unlikely. Additionally, RBI has structured the bonds in a manner that in the unlikely event of this occurring, the investor still receives the principal back.
When it is too good to be true, it usually 'is' too good to be true. Let's look at cases where the bond may not offer great value to investors.
In an environment where inflation rates are already high, and are likely to fall, an investor may be better served buying a fixed maturity instrument (a la FMP) which offers a high fixed rate. As inflation falls, the yield on the FMP may turn out to be higher than on the IIB--despite the real return. IIB's therefore may make more sense in a rising inflation scenario especially where the interest rates are unnaturally subdued by government or RBI action.
Another key dampener is the presence of institutional investors subscribing to IIB issuances. RBI issued IIBs in Q1 of the current fiscal where institutional investors were expected to bid for bonds to determine coupon rate. Many such investors are entities controlled by government. This automatically skews the bids in a direction that suits the government--lower payouts--the exact opposite of what suits the retail investor. If RBI is serious about involving retail households and offering them a real protection against inflation, it needs to be honest about the cost of doing so.
The tax angle
A possible confusion could be taxation on these bonds. RBI has clarified that IIBs are not tax free. However, it is not clear whether the increase in principal as a consequence of inflation indexing will be treated as capital increase or as income in the year.
The assumption is that only coupon will be treated as income, while the rest goes as capital and is treated as capital gains at the time of redemption. Since indexation is allowed while computing capital gains, for the sake of consistency, the tax indexation should be the same as that used in modifying the principal. In such a case, there should be no tax on redemption. This is not likely to be the case.
The income tax authorities will likely use their own series for inflation adjustment, which will, in all probability, be lower than the adjustment factor applied to the bond-resulting in some capital gains. Alternately the principal adjustment could be treated as income in the year of accrual. In either case, IIBs are no less tax efficient compared to tax on a comparable bond, in the first case, they are significantly better. Tax efficiency may be higher in the case of a debt mutual fund though--and this is something that could worry the retail investor. An early clarification on this would help.
An alternative to gold
Assuming that there are no attempts to downplay CPI, and investors trust that they are indeed protected against inflation, CPI indexed IIB's are probably the most potent step that the government has taken to reduce Indian household's love for gold. Quantitative restrictions or higher tariffs--both of which have been introduced-have a tendency to push the gold trade underground. Offering positive real interest to investors will go a long way in restoring viability of financial savings in the portfolio of Indian savers. Of course, this calls the bluff of all those who have been advocating lower interest rates--despite persistent negative real interest rates.
IIBs, if widely traded, offer a precise way to measure inflation expectation of investors. This, in theory, is supposed to push governments towards greater fiscal prudence--since the market signal will set the tune for other forms of government financing as well. If heeded, this would indeed be a great step. IIBs have the best chance of inducing genuine retail interest in government securities market. Let's hope they work.