Reserve Bank of India recently launched Inflation Index Bond also known as Inflation-linked bonds or Inflation Indexed National Savings Securities. These bonds are launched in the backdrop of announcement made in the Union Budget 2013-14 to introduce instruments that will protect savings from inflation and also with increasing preference of investors for diversified instruments and to further improve the depth and width of G-Sec Market, it has been felt that Inflation Indexed bonds could be issued at the current juncture.
Inflation-indexed bonds are a new category of debt instruments introduced in India. These bonds were earlier issued in 1997 in the name of Capital Indexed Bonds but they are not in the market anymore due to:
a) Lack of an enthusiastic response of market participants for the instrument, both in primary and secondary markets.
b) Provided inflation protection only to principal and not to interest payment.
c) Complexities involved in pricing of the instrument.
Taking into account past experience as well as the internationally popular structure of Capital Indexed Bonds, a modified structure of Inflation Indexed Bonds has been designed will provide inflation protection to both principal and interest payments. The main reason for introduction of these bonds is to lure investors away from gold, the imports of which have widened India’s current account deficit and also to channelize savings into productive sources of instruments, especially the savings of the poor and middle classes.
Features of these bonds are:
- Links its cash flow to actual inflation levels so that the real rate of return matches the nominal interest rate of the bond. In this way, both investors and issuers forgo the risks of fluctuating inflation levels in the future.
- The Bonds will bear interest at the rate of 1.5% (fixed rate) per annum + inflation rate calculated with respect to final combined Consumer Price Index [(CPI) Base; 2010 = 100]. Final combined CPI will be used with a lag of three months to calculate incremental inflation rate (i.e. final combined CPI for September would be used as reference CPI for all days of December). Interest will be compounded with half-yearly rests and will be payable on maturity along with the principal. E.g. CPI of 11.24% in November 2013 means you can expect to get 12.74% pa assuming the inflation stays at same level.
- Although interest will be calculated every six months, investors will not receive periodic interest payments. The principal and accumulated interest will be paid when the bonds mature.
- The Bonds shall not be tradable in the secondary market. The Bonds shall be eligible as collateral for loan from banks, Financial Institutions and Non-Banking Financial Company (NBFC).
How they will work?
- As described, there will be two parts in the interest rate-consumer price inflation rate and a fixed rate of 1.5% per annum. The interest would be compounded every six month. For example, if inflation rate during the six months is 6%, then interest rate for this six months would be 6.75% (fixed rate of 0.75% calculated on a semi-annual basis and inflation rate of 6%).
- The 1.5% fixed rate would also be the floor rate, which means that even if inflation turns negative, investors will earn at least 1.5%.
- The tenure of these bonds will be 10 years and they will be available at all nationalised banks, HDFC Bank, ICICI Bank and ICICI Bank and Stock Holding Corporation of India
- Limit of Investment: Minimum limit for investment in the bonds is Rs 5,000/- and maximum limit for investment is Rs 5,00,000/- per applicant per annum.
- Issue Price: The Bonds will be issued at par, i.e. at 100.00 percent and will be for a minimum amount of Rs 5,000/- (face value) and in multiples thereof. Accordingly, the issue price will be Rs 5,000/- for every Rs 5,000/- (Nominal).
- These securities will be issued in the form of Bonds Ledger Account (BLA). The securities in the form of BLA will be issued and held with RBI and thus RBI will act as central depository.
- Applications for the Bonds in the form of Bonds Ledger Account will be available for sale till 31st March 2014 and will be received at:
(a) Branches of State Bank of India, Associate Banks, Nationalised Banks, three private sector banks (i.e. HDFC Bank Ltd., ICICI Bank Ltd., AXIS Bank Ltd.) and Stock Holding Corporation of India (SHCIL) during their working hours.
(b) Any other bank or number of branches of the banks and SHCIL where the applications will be received as specified by the Reserve Bank of India in this behalf from time to time.
The Bonds shall be repayable on the expiration of 10 (ten) years from the date of issue. The investor will be advised by the authorised bank one month before maturity regarding the ensuing maturity of Bonds advising them to provide a Letter of Acquaintance, confirming the NEFT/NECS account details, etc. to the authorised bank. If everything is in order, the investor will be paid within maximum five days of the maturity.
Early repayment/redemption before the maturity date is allowed after one year of holding from the date of issue for senior citizens, i.e. 65 and above years of age and for all others, after 3 (three) years of holding, subject to the penalty charges at the rate of 50% of the last coupon payable. Early redemption to be allowed only on coupon date. For example, if last payable coupon is Rs. 1,000/-, then Rs. 500 would be charged as penalty.
An example of cash flows/ compounding of principal for illustration purpose is as under:
Fixed rate 1.5% per annum
Issue/ Coupon/ maturity date
Interest rate (Compounding rate)
What does it mean for investors?
This is definitely a welcome product for retail investors. These bonds can be used to diversify and stabilize the portfolio. This is because their principal rises with inflation. But when inflation falls, the principal does not go below the issue amount.
These bonds are redeemed at the inflation-adjusted principal or the amount for which they were issued. These bonds will give more choice to savers, particularly those who are risk-averse and looking to get assured positive real returns. Like gold, these are a hedge against inflation and store of value. Investors who desire predictable real cash flow can include indexed bonds in their portfolio.
The interest is simple to calculate and gives returns above inflation which means your money is really growing. It is a highly safe investment and indexing it to CPI is the meaningful part as the ordinary investor will benefit from it. Since you get the bond through banks, it means that you will be able to access it easily. Remember that it is a long-term investment as you have to stay invested for at least 10 years. There is a lock-in period for the product. For senior citizens the lock-in period is one year and for other it is three years. RBI states that if redeemed before maturity, the penalty charges will be at the rate of 50% of the last coupon payable for early redemption. Hence, if you redeem before 10 years and after the lock-in, then there is a penalty. In absolute terms, it may not be much but if you consider the current rate of CPI inflation (10%) the charge could be at least 5% of your invested value—5% assuming that 50% of the last coupon payable refers to the actual value of the coupon.
Overall this is a good product with AAA rating and a sure above-inflation return. But there is no tax incentive. Interest on the Bonds will be taxable under the Income-Tax Act, 1961 as applicable according to the relevant tax status of the bonds holder.
Advantages of IINSS-C (Inflation Indexed National Savings Securities)
• Inflation has been high in India in recent years; this bodes good returns and protection from inflation by investment in IINSS-C (. The safety of the principal should not be a cause of concern as the bonds are a part of the government’s borrowing programme. IINSS-C will be considered at par with sovereign rated government securities (G-Secs).
• Even though IINSS-C will be taxed like fixed-deposits (FD), the interest can be substantially higher than FDs during a period of high inflation. Conversely, the returns can go lower than FDs, when inflation is low. FD rates can also go low when inflation dips and, hence, IINSS-C should be preferred over FD, as long as you have a commitment to stay with the product for a long term. For example, CPI of 11.24% in November 2013 means you can expect to get 12.74%pa (per annum) assuming inflation stays at the same level. With inflation levels fluctuating, the returns from IINSS-C will have a zigzag pattern. Scheduled commercial banks offer approximately 9%pa for 10-year FDs which is guaranteed for the full period.
• The product should be easy to purchase from banks; servicing it should not be an issue due to bank involvement. It can be used as collateral for loans from banks, financial Institutions and Non Banking Financial Companies (NBFC). The transferability is limited to nominee(s) on death of holder (only individuals).
• IINSS-C can be used to diversify one’s debt portfolio. Their advantage over bonds is that technically the principal is protected in IINSS-C. Selling bonds (taxable or tax-free) during high interest regime can result in getting a price lower than the principal. Early redemption of IINSS-C, after expiry of the lock-in period will ensure that you get back your principal even if inflation falls drastically; but you will take a beating due to the penalty on the coupon rate. It works more like bank FDs which have a penalty on premature withdrawal.
IINSS-C is more like FD, less like a bond. IINSS-C surely has an advantage over taxable and tax-free bonds for the conservative saver who does not like the volatility of the investment amount, based on market interest rates.
• IINSS-C should dissuade savers from buying gold for investment purposes. Beating inflation with gold has been a fallacy; IINSS-C should be an option for this segment as it will actually make your money grow at a rate higher than inflation. It can be an instrument for retirement savings.
Disadvantages of IINSS-
• The bonds are meant to be long-term savings instruments. They will not be tradable in the secondary market. Liquidity is certainly an issue with IINSS-C.
• Hefty penalty for early redemption is a major deterrent.
• The Finance Bill of 2012 had lowered the age of senior citizens from 65 years to 60 years for tax benefit purposes. The circular of RBI on IINSS-C, which states that 65 years has to be considered for qualifying as a senior citizen, has brought back the debate on senior citizen’s age.
• IINSS-C does not match the charm of public provident fund ( PPF) which allows Rs1 lakh investment in a year for tax deduction under Section 80C. Moreover, interest on PPF is tax free. IINSS-C may not even score over tax-free bonds, especially for savers in the 30% tax bracket. The recent tax-free bonds issues offered coupon rates of 8.66% and 8.76% for AAA and AA+ rated bonds, respectively, of 10-year tenors.
• Rate of interest on IINSS-C will be floating which may not be suitable for those in need of fixed income. Moreover, absence of income flow can make the product unattractive for senior citizens. I
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