Inflation Indexed Bonds (IIBs): Why 2% Coupon is a Good Idea Posted by Uma Shashikant and Deepa Vasudevan on Fri, May 31st, 2013 All fixed income assets are exposed to inflation risk. Investors know that getting back the principal of Rs.100 after 10 years is not adequate, if inflation has moved up in the interim. Even government securities – which offer government guaranteed returns – are safe only from the possibility of default. Inflation can erode the value of, and therefore returns from, the “safest” of investments. Investors should, therefore, welcome the decision of the RBI to auction its first tranche of Inflation Indexed Bonds (IIBs) on June 4, 2013. A bond has two types of pay-outs- (i) Periodic interest payments and (ii) Principal redemption at maturity. Ideally, a bondholder would like both pay-outs to be protected from inflation. In reality, inflation is a changing number not amenable to exact prediction. Therefore adjustments to inflation have to be made periodically. In an inflation indexed bond, each time a pay-out is made, it is adjusted for the inflation at that point in time. (Economists know this as contemporaneous inflation). If the objective is to protect the investor from an unknown change in inflation, this is best done by doing two things: (i) indicate a real rate of return and (ii) pay this real rate on an inflation-adjusted principal. RBI’s design of IIBs does this efficiently. The interest rate in an IIB is typically a small percentage, say 1-2%. This is because the coupon does not compensate for inflation. It is a real rate. Consider a 10-year rate of 8%. This coupon can be divided into (1) a real rate (2) compensation for inflation and (3) uncertainty premium that is payable because investors cannot be sure about what inflation will be during the tenure of the bond. The bond gets issued at 8% if, at the time of its issue, the market is willing to accept 8% as a fair compensation for all these three factors. If investors think inflation will be around 6%, plus an uncertainty premium 1%, then the real rate is 1%. What the IIB does is primarily pay the real rate and a portion of the uncertainty premium as coupon. The interesting element in the IIB is the adjustment of principal to inflation, and the indirect benefit to the investor when a fixed rate is paid on this adjusted principal. The net effect is that both principal and interest are adjusted at the same inflation rate, on a periodic basis. The efficiency in this structure is that information about inflation as it is known during the tenor of the bond is incorporated into the returns to the investor.
Posted on: Sat, 15 Jun 2013 05:37:30 +0000
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