Inflation Indexed Bonds vs. Gold
You invested certain amount at a fixed interest rate of (let’s say) 8% for a year. The average annual inflation for that year turned out to be 10%. How much money would you ‘actually’ make at the end of the year? Well, you will lose 2%! Inflation eats into fixed income securities, eroding wealth and discouraging people from putting money in the banks. That money is diverted to buying items which will benefit from the rising inflation and can be easily sold too. Gold is the safest such option. The government will launch the first tranche of inflation-indexed bonds (IIBs) worth Rs.1,000 crore today (June 4, ’13) through auctions to take away household savings from gold by providing an alternative avenue for hedging against the price rise for a positive real return on investment. We have previously analysed the devastating impact of Gold Imports on our Current Account Deficit. We also know what goes wrong when the CAD becomes high through our session – ‘the deficit disaster’. Today we look at the theory behind the IIBs – Inflation Indexed Bonds. Let us see if they can outshine gold!
About the IIBs
In the last many months, depositors have seen negative returns on fixed income investments (like fixed deposits), as inflation has been high and interest rates (comparatively) low – while inflation had been hovering at about 10 per cent (it has come down in the months of April and May – but still above the RBI’s ‘comfort level’), interest rates on fixed deposits stood at an average of eight per cent, leaving investors saddled with a loss of two per cent on their investments.
The Reserve Bank of India launched inflation-indexed bonds, a boon during times of high inflation.
These bonds would be linked to the Wholesale Price Index (WPI) – which may also be a reason why many investors will stay away from them (more on this in a bit)!
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.
If it sounds confusing, here is an example. You invested 100 Rs at a rate of 8% in the IIBs. The average annual inflation turns out to be 10%. Now, you will be paid 8% on Rs 110 (not 100, as in the case of other fixed income bonds). So under IIBs you will get back 110 x 108% = Rs 118.80 while in the other case you would have only got 100 x 108% = Rs 108!
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