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Lately, depositors have seen negative returns on fixed income investments, as inflation has been high and interest rates low - while inflation has been hovering at about 10 per cent, interest rates on fixed deposits stand at an average of eight per cent, leaving investors saddled with a loss of two per cent on their investments. However, that might not be the case anymore.
Soon, the Reserve Bank of India will launch inflation-indexed bonds, a boon during times of high inflation. These bonds would be linked to the wholesale price index (WPI).
How it works
Inflation-indexed bonds would have a fixed real coupon rate and a nominal principal value, adjusted against inflation. Periodic coupon payments are paid on an adjusted principal. Therefore, these bonds provide inflation protection to both the principal, as well as the coupon payment. Since the coupon would be paid on the adjusted principal, the final yield, or the cash the investor receives in hand, would fluctuate, depending on the WPI movement. On maturity, the investor would receive the adjusted principal or the face value, whichever is higher.
Assuming the principal amount is Rs 1,000 and the coupon is fixed at eight per cent, if inflation is stable, the return would be Rs 80. But if inflation rises five per cent, the returns would be calculated on Rs 1,050. At an eight per cent coupon rate, it works out to Rs 84.8. In the first tranche (June 4), Rs 1,000-2,000 crore of inflation-indexed bonds would be issued, of which 20 per cent would be reserved for retail investors. Based on initial issuances, the second series of these bonds for retail investors is proposed to be issued in the second half of this financial year, RBI has said.
The central bank is yet to issue details on how these bonds would operate. In a recent conference call, it had said retail investors could participate in these bonds through demat accounts, and the minimum amount for retail participation would be fixed at Rs 10,000. There will be no special tax treatment for these bonds.
Who should invest
An advantage these bonds have is since the principal would be readjusted for inflation, the real returns on the portfolio would remain, says Kapil Narang, chief operating officer, Ameriprise India.
"Retail investors should consider investing in these bonds, as these are inflation-adjusted and, therefore, commit a real rate of interest to the investor, against regular bank fixed deposits (FDs), which pay a fixed coupon on the principal. Therefore, if you had invested Rs 1 lakh in a five-year bank FD with eight per cent interest and annual payments, your payments would be fixed at Rs 8,000, though the real value of this would deplete, due to a rise in inflation. In fact, there is also a possibility of your money growing negatively," Narang says.
Nikhil Naik of Naik Wealth says, "Given the safety of these bonds, it might not be a bad idea to have some amount of your fixed-income portfolio in these." But as interest rates are headed downwards, it might be better to lock into bank FDs, which are close to their peak rates. Or invest in debt mutual funds, which could give capital gains when interest rates fall. Since these bonds would be issued for 10 years, these are best suited for investors with a long-time investment horizon. Historically, in developed markets, such bonds were beneficial for investors with a long-time horizon, said Nitin Vyakaranam, founder and chief executive, ArthaYantra.
These bonds would also work well for investors looking at real regular income, as interest payments are made semi-annually, adds Narang.
Things to watch out for
The real benefit these bonds have over FDs would depend on the final coupon rate, says certified financial planner Gaurav Mashruwalla. "The fact that they are linked to the WPI means returns would not be flat, which is good. But we need to watch what the actual coupon rate would be. For instance, if the returns, that is, WPI plus coupon rate, are the same as those on other fixed-income instruments, these are not very attractive. If I have to invest in these bonds, they must offer higher returns than FDs," he says.
In their current form, another disadvantage inflation-indexed bonds have is the interest is linked to the WPI. Compared to WPI, the consumer price index (CPI) is a better representative of the consumer's purchase power. From a retail investor's perspective, linking the interest with CPI is more beneficial, says Vyakaranam. In April, WPI-based inflation stood at 4.9 per cent, while CPI-based inflation stood at 9.4 per cent. Since the differential between these indices is substantial, if the interest is linked to CPI, these bonds could act as an alternative investment to gold, by offering a hedge against inflation, Vyakaranam says. Liquidity is another important factor to consider. Mashruwalla says investors should wait and see what liquidity options these bonds offer, once listed.
Bottom line
Retail investors can include inflation-indexed bonds in their debt portfolios, as these provide a hedge against inflation. Though the coupon rate is fixed, it would be paid on the adjusted principal, which would vary, depending on inflation. This means the final yield would vary, according to inflation. Nevertheless, investors should invest in these bonds for the long term.
