Bonding at the right time

With the rise in 10-year yields and fall in CPI, the numbers are in Raghuram Rajan's favour to launch inflation-indexation bonds

Raghuram Rajan, the new governor of the Reserve Bank of India (RBI), in his maiden speech on Wednesday made several proposals. A key one — introducing inflation-indexation bonds (IIBs) linked to the consumer price index in November 3 comes at a good time.

When RBI had re-launched IIBs this June, it was linked to the wholesale price index (WPI). Obviously, retail investors were not too enthused. The first tranche of the 10-year Rs 1,000 crore saw only Rs 14 crore from retail investors. This, despite the fact that 20 per cent of the issue was earmarked for them.

However, to be fair to RBI, the numbers were not really in their favour. The 10-year bond yield in June was at 7.44 per cent, whereas the CPI (industrial worker) was at a whopping 11.06 per cent and CPI (new series with base year 2010) was at 9.87 per cent — difference was 2.43 per cent between 10-year yields and CPI new series.  

The latest numbers of July show the gap between 10-year bond yield and CPI (new series) has narrowed to 1.47 per cent. While the CPI number of August will be declared in September 12, according the Bloomberg estimates, it is expected to be 9.64 per cent. “There were fears of cannibalisation when the difference between the CPI and bond yields was quite high. Now with the difference coming down and CPI likely to fall further, things are more favourable for RBI to launch these bonds,” said a banker.

In June, the first auction for the new instrument, the cut-off yield of the 10-year inflation-indexed government stock 2023, was fixed at 1.44 per cent. With the wholesale price index-based inflation at 6.62 per cent in January, the effective interest rate for these was 8.06 per cent.

The launch of these bonds in November also means that retail investors can finally look at debt investments that will beat CPI — the index that impacts them directly. N S Venkatesh, head of treasury at IDBI Bank, said: “Launching CPI-linked indexed bonds is a very good measure and we expect it will get a very good response. These bonds will fully protect retail investors from inflation-related worries.”

If the scheme offers good rates, investors might also move away from gold, said Vidya Bala Mutual Funds Research, FundsIndia.com. The rise in gold investments has hurt the current account deficit.

  The recently-launched IIBs had one important difference. In 1997,  when such bonds were under with the name of Capital Indexation Bonds, they did not give inflation benefit on interest income. But in these bonds, when the price of the bond goes up due to inflation, the interest will be paid on the adjusted principle. In other words, if the investment is Rs 10,000, inflation at five per cent for the year and coupon rate at three per cent, the interest will be paid on Rs 10,500. If the same benefit is extended when these bonds are linked to CPI, investors stand to gain further.

However, investors should remember that since the CPI rate is a floating number, the returns from these bonds can fall, too. In addition, what could hurt investors more is there will be no tax benefit from these products. So, depending on your income tax bracket, the tax could be anywhere between 10 and 30 per cent on the interest income. That would bring down returns further.

The benefit would accrue to the investor when the bonds mature as debt instrument get inflation indexation benefit. That is, the tax will be 10 per cent without inflation indexation or 20 per cent with inflation indexation. Suresh Sadagopan of Ladder7 Financial Advisory Services, said: “If the structuring of these bonds is attractive, we will definitely recommend it. Today, even one-year FMPs (fixed maturity plans) give post-tax returns which are 10 per cent. Hence, these bonds really need to yield better in order to be of some use to the common man.”