Inflation-indexation bonds: Do you have a ledger account?

While the rate of interest is attractive, you will have to pay tax annually like in cumulative fixed deposits. Check if it interests you

With the Reserve Bank of India declaring its first tranche of inflation-indexation bonds, the Inflation-Indexed National Savings Certificate Cumulative (IINSC), linked to the Consumer Price Index from Monday, investors can look forward to the product that can be used as a hedge against gold.

The interest rate on offer will be 150 basis points more than the composite inflation rate. For the month of December, the rate of inflation would be 9.8 per cent (September combined inflation). Consequently, the interest rate on offer is 11.44 per cent.

But before you jump to buy these bonds, here are some things you need to know. Things that could start from the very beginning. For example, the process of buying and redeeming the units. According to Harsh Roongta, chief executive of ApnaPaisa.com, "While it is proposed that the sale will be undertaken through the banks - nationalised and three private sector HDFC, ICICI and Axis or Stock Holding Corporation of India who will open what are called Bond Ledger Accounts (BLAs)? Very few retail consumers currently hold such accounts. Also, it is not known how cumbersome it is going to be to open such BLAs or how much it will cost to maintain it annually."
 

Second, there is a complete lack of clarity about the redemption process. RBI has said early redemption can be made on two specific dates in a year. But it could lead to procedural problems. While bankers say RBI will come to an average of inflation rates for the six months and pay 150 basis points over and above it, the question is how the taxman will treat it.

At present, if you invest in a three or five-year cumulative fixed deposit, you need to get an interest rate certificate after deducting tax deductible at source (TDS), even though there is no income in the year, and submit it to the tax department.

Similarly, in the case of such bonds, though there won't be a cash flow, there would be a tax to be paid on the returns.

"As the interest is compounded every six months, there is no cash flow at all possible for 10 years, unless you redeem early. In fact, most investors will have to pay tax liability from their pocket, despite not getting the interest payment," adds Roongta.

The benefit comes from the rate of interest is sounding impressive because competing products like fixed deposits (five-year or more) or tax-free bonds are offering around nine per cent. In case of the former, there are benefits under Section 80C (up to maximum benefit of Rs 1 lakh) of investing. In the latter, the interest paid is tax-free.

As financial planner Amar Pandit says: "The interest on this issue (although only accrued and not paid to the investor) would be subject to tax, based on the marginal tax rate of the investor. Assuming a 10 per cent, 20 per cent and 30 per cent marginal tax rate, the post-tax returns would be nine per cent, eight per cent and seven per cent, respectively. Hence, the issue would be beneficial only for an investor in the 10 per cent marginal tax bracket and not for an investor in the 20 per cent or 30 per cent one. Also, if the interest rate goes down because of the floating nature of the product, investors will stand to lose."

That is why, Pandit says, these are best suited for investors with a long-time investment horizon and those not looking at a regular income.

According to Roongta, one benefit is investors paying higher taxes will also get a long-term capital loss for tax purposes in the year of redemption of the bond (whether early redemption or on maturity), which they can set off against any other long-term capital gains they might have in the year of redemption.

While the jury is still out on whether these products will work out well for the retail investor, Raghavendra Nath, managing director, Ladderup Wealth Management, believes once the economy improves the government may stop issuing infrastructure bonds. But inflation-linked bonds will continue as an investment option. "They are a good option for retail investors who mgiht not understand equities, which is the other investment that can beat inflation," he argues.

SPECIFICATIONS:

• The IINSS-C issue will open on Dec 23 and close on Dec 31. RBI could also close it earlier
• The minimum limit for investment is Rs 5,000 and the maximum limit is Rs 5 lakh for an applicant
• The bonds will be issued at par
• Eligible investors include individuals, a Hindu undivided family, charitable institutions registered under Section 25 of the Companies Act, central and state government universities
• Interest rate would comprise two parts - a fixed rate of 1.5 per cent per annum and an inflation rate based on the CPI, which will be floating
• The floating rate will be compounded in the principal on half-yearly basis and paid at maturity
• The final combined CPI (urban + rural CPI) will be used with a lag of three months, that is, the final combined CPI for September 2013 will be used as a reference CPI for all days of December 2013
• Although the maturity period for the bonds is 10 years, early redemptions will be allowed after one year from the date of issue for senior citizens (65 years and above) and three years for others. However, this will attract penalty charges at the rate of 50 per cent of the last coupon payable. Early redemptions can be made only on coupon dates
• IINSS-C would be distributed through public sector banks and three private sector banks (ICICI Bank, HDFC Bank and Axis Bank) and Stock Holding Corporation of India
• There is no tax benefit on these bonds, neither tax exemption on investment as in case of FDs nor tax-free returns as in case of tax-free bonds. The interest will be added to the investor's income and taxed in the bracket applicable