Should India Take Another Stab At Inflation-Indexed Bonds?

As inflation has risen, so has the desire of investors to protect their capital. Bank deposits are offering interest rates below inflation, meaning your capital erodes over time. Equities are volatile. Debt is riddled with uncertainty over central bank action. Cryptocurrencies? The less said the better.

In such a scenario, could inflation-indexed bonds come to the rescue of those seeking to protect their investments?

Broadly, inflation-indexed bonds are securities designed in a way to protect your investment from inflation. These securities offer higher principal and interest as inflation rises (and lower if it falls), so your inflation adjusted returns remain fixed.

A number of countries, the U.S. and the U.K. among them, have such securities. India, though, has seen its past attempts to launch such securities fail. Against a background when inflation has risen to above 7%, and promises to be volatile, should India give these securities another shot?

The first attempt to launch inflation-indexed bonds came in December 1997, when the RBI issued capital-indexed bonds. These only partially protected investors, by adjusting the principal amount in line with inflation but didn't offer the same protection on coupon rates.

According to a 2004 paper available on the RBI's website, there was no further issuance of capital-indexed bonds because the response from market participants was less than enthusiastic. It attributed this to the fact that only principal was protected and the complexities involved in pricing the instrument.

The paper went on to suggest a re-design. As a first step, the coupon payment should also be protected from inflation, it said. "The basic feature of bonds would be that the coupon rate for the bonds would be specified in real terms." The principal repayment at maturity would be the inflation-adjusted principal amount or its original par value, whichever is greater, it suggested. "Thus with an in-built insurance that at the time of redemption the principal value would not fall below par.

At the time, since the wholesale price index was more robust, it was suggested that these securities be linked to WPI.

Nearly a decade after the paper, the RBI attempted inflation-indexed again in 2013.

This time around, protection was provided both on principal and interest. According to product details available on the RBI's website, the inflation component on principal was not paid with interest but was adjusted in the principal. At the time of redemption, adjusted principal or the face value, whichever is higher, would be paid. The coupon rate will be provided protection against inflation by paying a fixed rate on the principal adjusted against inflation.

This product was linked to WPI.

In June 2013, RBI sold WPI-linked bonds offering a real yield of 1.44%. The response this time was also poor.

Soon after it was launched, India saw a dramatic change in its inflation regime. The RBI first moved informally towards targeting consumer price inflation and then eventually accepted a formal CPI inflation target of 4 (+/-2)%.

The result was that the 2013 series of bonds became virtually redundant. In January 2016, the government bought back Rs 6,500 crore in these securities.

According to the fixed income head of a mutual fund, who spoke on condition of anonymity, besides being linked to the wrong inflation index, the pricing formula for the 2013 was seen as faulty by the market. In addition, banks struggled with accounting for the returns on the product on a quarterly basis.

The retail version of these securities were issued in the form of inflation-indexed national savings securities. These were finally linked to the consumer price index, offered a 1.5% real return. This acted as a floor. The interest was accrued and compounded in the principal on half-yearly basis and paid along with principal at the time of redemption, according to the details available.

A number of countries like the U.S., via the Treasury Inflation Protected Securities, and the U.K, via inflation-linked bonds, have had successful markets for such instruments for years.

Publicly available data suggests that many of these countries get 5-7% of their annual borrowings via inflation-protected securities with tenures ranging from 5-30 years.

• In the U.S., for instance, TIPS securities have made up between 4-6.5% of annual issuance between 2017 and 2021.

• In the U.K., they have accounted for a higher 10-20%.

The first issue, according to the fund manager quoted above, is to get the pricing structure for these securities correct and ensure that banks and insurance companies would be keen to subscribe to them. Issues such as accounting of the returns should be resolved upfront. Without banks and insurance companies participating, these securities would not have adequate liquidity. Mutual funds will follow if there is a liquid market, this person said.

Second, the tenor for the securities should be 3-5 years at least till the market becomes familiar with them. Issuing a relatively unfamiliar product in longer tenor buckets will turn off investors, this person said.

The government and the RBI would also need to issue these with some regularity as part of their borrowing calendar.

At the retail levels, views are mixed on whether such securities would see a good response.

Fixed deposits are not useful in protecting investors from inflation, said Neville Poncha, founder of Percipient Capital. As a product, it would be useful in protecting pensioners, among others, from inflation, he said. While it is true that most investors look at absolute returns, at times of high inflation, a product like this would resonate, he added.

Poncha believes there would be institutional and retail investor interest in the product since the market has evolved from the time inflation-indexed bonds were last attempted. He, too, believes that securities in the 3-5 year bucket would get more interest than those where money is locked in for longer.

Financial planner Gaurav Mashuwala is not sure retail investors will bite. People don't really comprehend the idea of real rates, he said. Typically, the mindset of retail fixed income investors is to look for predictability, he said.

Besides, with any new product, question of taxation, commission to sell will become an issue. "Who will sell? Who will explain this?," he asked.