 "RBI's inflation bonds will lack liquidity")
Retail investors will soon be able to hedge their investments against the much feared inflation monster. The Reserve Bank of India has announced that the Inflation Indexed National Savings Securities-Cumulative (IINSS-C) will be launched in the second half of December 2013. But will they live up to investors' expectations? What are their advantages and disadvantages?
The biggest advantage is the protection against inflation. These securities will be linked to Consumer Price Inflation Index (CPI)-based inflation, which is a truer reflection of the price hikes that consumers have faced in the recent past.
The interest rates has two components. One is the fixed component, which is 1.5 per cent; the other is the floating component, which is linked to CPI. This will result in an additional rate of interest a good 150 basis points above the CPI rate. The interest will be paid twice a year, and so investors will also get compounding benefits and yields will be higher.
However, a disadvantage is low liquidity. One can't redeem these bonds until three years of date of issuance. After three years, this product will be redeemed only during coupon days, that is, whenever the interest is due to be paid on these securities. Interest on these securities will be accumulated half-yearly, but will be paid only on maturity, or after redemption, whichever is earlier. Hence, investors looking for a regular income will not find it here.
However, senior citizens have been given a facility to redeem these bonds after the first year. But the definition of senior citizens has changed for this product. The RBI circular will allow senior citizens to exit after one year but only if they are 65 years and above. In other words, the anomaly that was removed in the Budget 2012 by lowering the age of senior citizen to 60 years from 65 years for tax benefits has been reintroduced for this particular instrument by the apex bank. Also, one will not be able to exit whenever one wants to. The redemptions will only be allowed on coupon dates.
The tax incidence on these products will be as per capital gains tax rules, that is, 10 per cent without indexation and 20 per cent with indexation. Due to this, the IINSS-C is better than bank FDs, whose interest is taxed as per your income-tax bracket. However, according to Kiran Kumar Kavikondala, director, WealthRays Group (Securities and Commodities), the new product will offer higher returns than fixed deposits (FDs). Currently, the post-tax returns from an FD that offers 9 per cent interest rate works out to around 6 per cent.
"FD investors are going through a rough patch because the returns are nowhere close to the real interest rates. Considering that most of Indian's savings go to bank FDs, this new product is a much better option," Kavikondala says. These are definitely a good option for anyone who is looking at fresh investments. But if you are already invested in bank FDs, you can continue with your existing investments.
Of course, this product will be much better than the earlier version - the wholesale price index (WPI)-linked bonds. And in circumstances when the difference between CPI and WPI has been a good 4-5 per cent, retail investors weren't gaining much. However, even with this relief, retail investors should invest in these bonds only if they have a surplus that they do not want to withdraw in the next few years. Also, given that the rate of interest will be floating in nature, many might prefer products that give fixed returns.
Typically, most FD investors don't stay invested for more than three years, says Kavikondala. So, the lock-in of three years may not be a big negative. In case investors are looking at a real long-term investment, tax-free bonds or non-convertible debentures are a better option because they offer higher yields than FDs.
Will the product be as good when CPI starts to fall?According to Ashutosh Khajuria, president, treasury, Federal Bank, that will be the real test of the securities. "Right now there could be high interest for the product because inflation is high. But when inflation falls, the interest rate on this product too will fall. Once investors get used to higher rates they will find it difficult to accept the lower rates," he said. But the idea behind the product is to provide retail investors a hedge for their investments against inflation, which was missing so far.
Another advantage of these new products is that just like FDs, investors can use them as collateral for taking loans from banks or non-banking financial companies.
But for them to be popular, bank staff will have to explain the product to customers. "Customers who are used to fixed interest rate FDs could find it difficult to understand the concept of two interest rates - one that is fixed and one that is a floating interest rate linked to CPI. So, banks will have to popularise the product and create awareness among customers for this," Kavinkondala says.
GOOD OR BAD?
The biggest advantage is the protection against inflation. These securities will be linked to Consumer Price Inflation Index (CPI)-based inflation, which is a truer reflection of the price hikes that consumers have faced in the recent past.
The interest rates has two components. One is the fixed component, which is 1.5 per cent; the other is the floating component, which is linked to CPI. This will result in an additional rate of interest a good 150 basis points above the CPI rate. The interest will be paid twice a year, and so investors will also get compounding benefits and yields will be higher.
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Given that the CPI (2010 base =100) inflation number came in at 10.09, the applicable rate of interest in this case will be 11.6 per cent. If one compares this return to that of bank fixed deposits, the popular fixed income investment among retail investors, there's a clear additional return 250 basis points that investors can make. On average bank fixed deposits offer an average interest rate of 9-9.5 per cent for about five years.
However, a disadvantage is low liquidity. One can't redeem these bonds until three years of date of issuance. After three years, this product will be redeemed only during coupon days, that is, whenever the interest is due to be paid on these securities. Interest on these securities will be accumulated half-yearly, but will be paid only on maturity, or after redemption, whichever is earlier. Hence, investors looking for a regular income will not find it here.
However, senior citizens have been given a facility to redeem these bonds after the first year. But the definition of senior citizens has changed for this product. The RBI circular will allow senior citizens to exit after one year but only if they are 65 years and above. In other words, the anomaly that was removed in the Budget 2012 by lowering the age of senior citizen to 60 years from 65 years for tax benefits has been reintroduced for this particular instrument by the apex bank. Also, one will not be able to exit whenever one wants to. The redemptions will only be allowed on coupon dates.
The tax incidence on these products will be as per capital gains tax rules, that is, 10 per cent without indexation and 20 per cent with indexation. Due to this, the IINSS-C is better than bank FDs, whose interest is taxed as per your income-tax bracket. However, according to Kiran Kumar Kavikondala, director, WealthRays Group (Securities and Commodities), the new product will offer higher returns than fixed deposits (FDs). Currently, the post-tax returns from an FD that offers 9 per cent interest rate works out to around 6 per cent.
"FD investors are going through a rough patch because the returns are nowhere close to the real interest rates. Considering that most of Indian's savings go to bank FDs, this new product is a much better option," Kavikondala says. These are definitely a good option for anyone who is looking at fresh investments. But if you are already invested in bank FDs, you can continue with your existing investments.
Of course, this product will be much better than the earlier version - the wholesale price index (WPI)-linked bonds. And in circumstances when the difference between CPI and WPI has been a good 4-5 per cent, retail investors weren't gaining much. However, even with this relief, retail investors should invest in these bonds only if they have a surplus that they do not want to withdraw in the next few years. Also, given that the rate of interest will be floating in nature, many might prefer products that give fixed returns.
Typically, most FD investors don't stay invested for more than three years, says Kavikondala. So, the lock-in of three years may not be a big negative. In case investors are looking at a real long-term investment, tax-free bonds or non-convertible debentures are a better option because they offer higher yields than FDs.
Will the product be as good when CPI starts to fall?According to Ashutosh Khajuria, president, treasury, Federal Bank, that will be the real test of the securities. "Right now there could be high interest for the product because inflation is high. But when inflation falls, the interest rate on this product too will fall. Once investors get used to higher rates they will find it difficult to accept the lower rates," he said. But the idea behind the product is to provide retail investors a hedge for their investments against inflation, which was missing so far.
Another advantage of these new products is that just like FDs, investors can use them as collateral for taking loans from banks or non-banking financial companies.
But for them to be popular, bank staff will have to explain the product to customers. "Customers who are used to fixed interest rate FDs could find it difficult to understand the concept of two interest rates - one that is fixed and one that is a floating interest rate linked to CPI. So, banks will have to popularise the product and create awareness among customers for this," Kavinkondala says.
GOOD OR BAD?
- New securities will have fixed interest rate plus floating rate linked to inflation
- Minimum investment is Rs 5,000; maximum investment is Rs 5 lakh
- Tenure is 10 years
- Penalty for early redemption is 50 per cent of the last coupon payable
- Redemption is allowed after one year from date of issue for those above 65 years and three years for others