Inflation Indexed Bonds

Finally, Inflation Indexed bonds are going to be issued by Government of India on 4th June'13.
The RBI will sell inflation-indexed bonds of 10-year maturities that would realise Rs 1,000-2,000 crore each month and aggregate to Rs 12,000-15,000 crore by the end of the fiscal. The principal will be indexed to the wholesale price index (WPI) with a four-months lag, while the coupon will remain fixed. Initially, these bonds will sold through auctions, to Mutual Funds, Insurance companies, Pension funds etc, for the purpose of price discovery and Market development. This will also  help creating a secondary market for these bonds.
                 These Inflation Indexed Bonds (IIB's) are reintroduced by GOI,after a previous attempt was made in 1997. The GOI and RBI are hoping that as these bonds will provide hedge against inflation, which will help in moving people away from Gold, which  is also considered a hedge against inflation. These steps are taken by the GOI, after the Current Account Deficit (CAD) has touched record levels. 
          

IIBs will be having a fixed real coupon rate and a nominal principal value that is adjusted against inflation. Periodic coupon payments are paid on adjusted principal. At maturity, the adjusted principal or the face value, whichever is higher, will be paid. The bond would be protected from inflation through the final WPI will be used for providing inflation protection in this product.Final WPI with four months lag will be used, i.e. Sept 2012 and Oct 2012 final WPI will be used as reference WPI for Feb 1, 2013 and March 1, 2013, respectively. The reference WPI for dates between Feb 1 and March 1, 2013 will be computed through interpolation.

How does it work?

If you pay Rs. 100 for a bond that tells you it will pay 6% a year, the normal expectation is to get Rs. 6 per year, because the 6% (“coupon”) is on the Rs. 100 (“principal”).

Inflation index bonds expect to change the principal but retain the coupon at the same rate. You will get 6% but on a higher or lower principal depending on how inflation goes.Effectively the amount of interest you receive moves with inflation.

Year 1: Let’s say inflation is 10%. That means the WPI index, which was 200 at start, is now 220. The calculation is that principal goes up by this amount and so does interest.

So, principal = issue time principal * (current WPI / WPI index at issue time).

or, principal = 100 * (220/200) = 110.

The New Principal is Rs. 110. Interest paid out = Rs. 110 * 6% (constant coupon). = Rs 6.6

Effectively the new principal went up. You can’t do anything with this new principal. But like the house you live in, you can feel good that its price went up.

Year 2: Let’s say inflation is 5%. So the WPI is at (220 * 105%) = 231.

Same calculations give us:

New Principal = 100 * (231/200) = Rs. 115.5

Interest paid out = 6% of 115.5 = Rs. 6.93.

Year 3: Inflation of 12% 

WPI = 258.72

New Principal = 100 * (258.72/200) = Rs. 129.36

Interest paid out = 6% of that = Rs.7.7616

If the bond now matures (note: maturity is 10 years for these bonds, but just saying) the New Principal will be paid to you as the principal. This becomes a capital gain. However, should the bond principal fall below Rs. 100 because the WPI index hugely deflates at maturity, you will get Rs. 100.

The bonds are issued by the government of India, in Indian rupees.Hence for Indian investors they are  risk-free.

   Hence, the rate of return = Average Inflation + coupon rate. That means a 6% coupon IIB will, at 8% average inflation will give you 14% rate of return. (6% + 8% inflation). 

                But the coupon rates on these bonds might just be somewhere around 1% or so, and  not such a high figure of 6%.

 

                           

The RBI will sell inflation-indexed bonds of 10-year maturities that would realise Rs 1,000-2,000 crore each month and aggregate to Rs 12,000-15,000 crore by the end of the fiscal. The principal will be indexed to the wholesale price index (WPI) with a four-months lag, while the coupon will remain fixed - See more at: http://www.indianexpress.com/news/inflationindexed-bonds-to-be-launched-on-june-4/1116500/#sthash.8JYxY43G.dpuf

The RBI will sell inflation-indexed bonds of 10-year maturities that would realise Rs 1,000-2,000 crore each month and aggregate to Rs 12,000-15,000 crore by the end of the fiscal. The principal will be indexed to the wholesale price index (WPI) with a four-months lag, while the coupon will remain fixed - See more at: http://www.indianexpress.com/news/inflationindexed-bonds-to-be-launched-on-june-4/1116500/#sthash.8JYxY43G.dpuf

The RBI will sell inflation-indexed bonds of 10-year maturities that would realise Rs 1,000-2,000 crore each month and aggregate to Rs 12,000-15,000 crore by the end of the fiscal. The principal will be indexed to the wholesale price index (WPI) with a four-months lag, while the coupon will remain fixed - See more at: http://www.indianexpress.com/news/inflationindexed-bonds-to-be-launched-on-june-4/1116500/#sthash.8JYxY43G.dpuf

The RBI will sell inflation-indexed bonds of 10-year maturities that would realise Rs 1,000-2,000 crore each month and aggregate to Rs 12,000-15,000 crore by the end of the fiscal. The principal will be indexed to the wholesale price index (WPI) with a four-months lag, while the coupon will remain fixed - See more at: http://www.indianexpress.com/news/inflationindexed-bonds-to-be-launched-on-june-4/1116500/#sthash.8JYxY43G.dpuf

The RBI will sell inflation-indexed bonds of 10-year maturities that would realise Rs 1,000-2,000 crore each month and aggregate to Rs 12,000-15,000 crore by the end of the fiscal. The principal will be indexed to the wholesale price index (WPI) with a four-months lag, while the coupon will remain fixed - See more at: http://www.indianexpress.com/news/inflationindexed-bonds-to-be-launched-on-june-4/1116500/#sthash.8JYxY43G.dpuf