Inflation Indexed Bonds (IIBs)
Inflation Indexed Bond (IIB) is a bond issued by the Sovereign, which provides the investor a constant return irrespective of the level of inflation in the economy. The main objective of Inflation Indexed Bonds is to provide a hedge and to safeguard the investor against macroeconomic risks in an economy.
Issue of IIBs has assumed significance in the context of high level of inflation experienced in the Emerging Market and Developing Economies during the recent years, as the value of money loses rapidly in an environment of high inflation. The issue of Inflation Indexed bonds in advanced economies is limited on account of low inflation experienced in these economies.
Operation of IIBs
For understanding the concept of IIB, it has to be compared with the instrument of fixed deposits with the bank. While fixed deposit offers a fixed rate of interest for the investment for a given number of years, it does not protect the investor from the erosion of real value of the deposit due to inflation. IIB on the other hand, gives a constant minimum real return irrespective of inflation level in the economy. Capital increases with the inflation, so actual interest is better than originally promised. In case of deflation, interest payments decrease with the negative inflation. However, capital does not decline below the face value, ie. Initial investment, in case of deflation. The working of IIB is given through the following example:
|End of the 1st year||End of the 2nd year|
|Principal : Rs 1000||Principal : Rs 103|
|Inflation in the economy : 3 percent||Inflation in the economy : 6 percent|
|Inflation accrual : Rs. 30||Inflation accrual : Rs.61.8|
|Principal at the end of the first year : Rs 1030||Principal at the end of the 2nd year : Rs 1091.8|
|Promised rate of return : 3 percent||Promised rate of interest : 3 percent|
|Interest : 1030 x 3/100: Rs 31||Interest : 1091.8 x 3/100: Rs 32.7|
|Totalreturn:Rs.30(inflation)+Rs:31(interest):Rs 61||Total return:Rs61.8(inflation)+Rs:32.7(interest): :Rs 94.5|
Thus, inflation component on principal is not paid with interest but the same is adjusted in the principal. At the time of redemption, adjusted principal or the face value, whichever is higher, would be paid. If adjusted principal goes below the face value due to deflation, the face value would be paid at redemption and thus, capital will get protected. Interest rate will be provided protection against inflation by paying fixed coupon rate/interest rate on the principal adjusted against inflation.
There are no special tax concessions for these bonds. IIBs are treated as government securities (G-Sec) and therefore, would be eligible for short-sale and repo transactions and gets SLR status (i.e., they are eligible to be kept as part of Statutory Liquidity Ratio requirements of banks).
In the Indian context, inflation was one of the major macroeconomic concerns of the economy during the period 2008-2013 where real interest rates were consistently negative. The period also was noted for the high current account deficit (CAD) , which saw huge investment in the alternate instrument – gold – by the households, necessitating heavy import of gold. In order to reduce the attractiveness of gold for investment and reduce the CAD, the Government of India launched Inflation indexed bonds (IIB) on 4 June 2013.
The Reserve Bank of India auctioned its first tranche, linking to Wholesale Price Index (WPI) inflation, as WPI headline inflation was then used as the key measure of inflation by RBI. IIB bonds were issued on monthly basis (on last Tuesday of each month) till December 2013. These bonds offered annual return of 1.44% (through half yearly coupon) over and above the headline inflation (WPI). These 10 year bonds could be traded in the Order Matching Negotiated Dealing Systems (NDS-OM), NDS-OM (web-based), Over the Counter (OTC) market, and stock exchanges. Approximately IIB bonds worth Rs 6500 crore were issued in 2013.
Over the time, IIB bonds lost its attractiveness, as there has been significant moderation in inflation since 2014-15. The IIB bonds turned highly illiquid, as WPI inflation remained negative for consecutive 15 months (as on Feb 2015) since November 2014. With a view to improve the liquidity in G Secs market, Government decided to buy back the IIB bonds. The Government of India announced the repurchase of 1.44% Inflation government stocks 2023 in February 2016 through reverse auction for an aggregate amount of Rs. 6500 crore (face value). The repurchase was undertaken as an adhoc measure to redeem the government stock prematurely by utilizing surplus cash balance.
Since April 2014, RBI adopted consumer price index (CPI -combined) as the key measure of inflation for its monetary policy stance. In case RBI issues new IIB bonds in the near future, it would be based on CPI, as CPI (combined) has been accepted by RBI as the key measure of inflation for its monetary policy stance, since 2014.
A predecessor of Inflation Indexed Bonds (IIBs) was Capital Indexed Bonds (CIBs) issued during 1997. However, the CIBs issued in 1997 provided inflation protection only to principal and not to interest payment. IIBs provide inflation protection to both principal and interest payments.