Should you invest in inflation indexed bonds? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Should you invest in inflation indexed bonds? 

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In this issue:
» Illegal gold imports increase amidst rising import duty
» Will China eventually de-control Yuan?
» Business sentiment in India turns weak
» Corporates' dream to set up banks may not materialize
» ...and more!

Hedging inflation risk is a critical concern for most investors. While gold does this job pretty well, there was a constant need to have a separate product that can address inflation risk. This gave birth to inflation indexed bonds (IIBs). In simple words, IIBs are bonds whose interest and principal repayment is indexed to inflation. In fact, some issues even offer a sop of 1-2% above the inflation level. This means that if the inflation level is 7%, as represented by Consumer Price Index (CPI), then the overall return will be 8-9% (1-2% higher).

Their ability to offer returns higher than the prevailing inflation rate should ideally make IIBs a preferred choice for investors. However, response to the current issue has been muted. Considering the inflationary trend prevailing in the economy this has come as a big surprise to many.

Let us first analyze the reasons behind the muted demand for IIBs. And then we will figure out whether they deserve a place in investor's portfolio or not.

The primary reason why IIBs are not able to garner investor interest now is because inflation is already showing signs of cooling down. The CPI inflation for the month of February was at a two year low of 8.1%. This obviously lowers investor return as coupons are indexed to inflation. In short, lower the inflation falls less attractive IIBs become. This is precisely what is happening now.

Secondly, while IIBs may be risk free, as the risk of default is virtually zero, they do not offer a fixed rate of return. Fluctuating returns do not make them a preferred choice for investors who prefer stability in income. Lastly, IIBs do not offer tax benefits. This makes them less attractive compared to other investment vehicles that offer tax benefits like tax free bonds or Public Provident Fund (PPF). All these factors have led to a poor demand of IIBs.

However, this was the case in the past as well yet the first ever issue was oversubscribed in few days. So, why is the response muted now and should investors consider investing in them at this stage?

The basic rationale for investing in IIBs is to hedge away inflation risk. And inflation in India has remained persistently high despite RBI being a hawk. That's because the central bank can do very little to curb food and fuel inflation as monetary policies are inefficient to do so. Also, both food and fuel components carry high weight in CPI index. This means that inflationary risks shall continue to haunt the Indian economy in future.

As a result, investors would be better off if they invest a small proportion of their fixed income portfolio in such bonds now. However, taxation and fluctuating returns are critical issues one should not ignore. Before investing in IIBs, investors should compare the post tax return of such bonds with other options available. Any decision should be taken from the post-tax perspective.

Have you invested in inflation indexed bonds ever? Do you think they offer a better hedge against inflation than gold? Share your views in the in the Equitymaster Club. Or post your comments below.

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01:50  Chart of the day
Defying tight interest rate scenario, private lenders have reported improved traction in current and saving account (CASA) share for the quarter gone by. And that's commendable! But what's more interesting is the CASA comparison amongst the private lenders! Have a look at the adjoining chart. Barring HDFC Bank, the CASA growth on YoY basis has remained steady for most of the private peers. Apparently, during the December quarter 2013, the CASA share declined for the bank with the highest market capitalization. Now that's clearly because the term deposits growth outpaced the CASA growth for HDFC Bank. But that really is no point to worry about we reckon. For private lenders have the mettle to firm up the low-cost deposit base. Attractive pricing, effective product branding and better customer relationship management have always helped private banks to augur healthy CASA base. And HDFC Bank as we know is a well respected private sector bank!

CASA* ratio of private banks soar
*CASA = Current account & savings account

There were cheers all around recently when India managed to lower its current account deficit to an impressive US$ 4.2 bn during the December 2013 quarter. It was argued that the deficit beast which hurt us so badly in recent past had finally been tamed. The key reason was of course the huge drop in gold imports, which plunged more than 80% on a YoY basis. But this is only half the story we reckon. It isn't as if India's love affair with gold disappeared almost overnight. Instead, what came into the country through official means was now forced to take the unofficial route. Bloomberg highlights how illicit imports of gold in India doubled to 200 metric tonnes in the aftermath of the Government raising duties on gold about three times last year. This is a classic case of putting up a new distortion in order to correct an older one. And this is exactly what happens when haphazard policy measures are taken in order to make the near term finances look good. It should be noted that banning gold imports is akin to addressing the effect and not the cause. The real cause of high gold imports is persistently high inflation and lack of any safe avenues to earn positive real rates of return we believe. And unless these issues are tackled, no amount of import restrictions is going to help.

As much as the banking licenses are being eagerly awaited, their announcement may not bring enough cheer to India Inc. For as per Business Standard, the RBI is paying a lot of attention to warnings about issuing bank licenses to corporate houses. Economists and global financial regulators have cautioned that the risks of offering banking licenses to corporate outweigh the benefits. Regulators in the US and South Korea do not allow industrial houses to set up banks. Australia, Canada, UK and Hong Kong allow it with restrictions on ownership and voting rights.

Thus taking cues from these, industrial houses like Aditya Birla Nuvo, Bajaj group, Videocon and Reliance Capital may find it rather difficult to pass the RBI's test. Ones like the Tata group and Mahindra Finance have already withdrawn their applications. Moreover, when bank licenses were issued in 1993 and 2004, business houses were not considered. Even India Post may be given a miss due to its government ownership. Thus it appears that only specialized NBFCs and MFIs are in the fray for banking licenses.

China has received considerable flak for pegging its currency to the US dollar. Not surprisingly, the criticism has been more pronounced from the US which complained of an unfair advantage in trade because of this artificial peg. But in recent times, China has been more open towards opening up its currency market. In the latest such development, the People's Bank of China announced that it would double the allowable trading range for the Yuan against the US dollar to 2% from a midpoint rate it sets every day.

This effectively means the value of the Yuan will move in a much wider range than what it had done in the past. China, in recent times, had expressed its intention of opening up its economy, allowing more foreign investment and loosening exchange controls. And this latest development is a step towards that. Earlier, a depreciated Yuan was quite beneficial to China given that its growth in the past was largely fuelled by exports. Hence, it will be interesting to see how a gradual Yuan appreciation will influence its trade balance position going forward.

The BSE-Sensex is looming around the 22k mark. With the upcoming general elections likely to result in change of leadership, the market sentiments seem poised for a revival. It is being widely anticipated that the new leadership will be able to dislodge the policy logjam and spur economic growth. But it would be a bit too risky to assign too much weightage to what is expected to happen in the future post elections.

As of now, the business scenario does continue to appear grim. If the results of a certain Business Sentiment Survey are to be believed, the outlook for India does not appear very bright. Rising inflation and the global economic uncertainty remain the biggest risk factors. The economic prospects of China and Australia too remain fragile. As such, investors building in too many positive expectations following the elections should exercise caution. Any unforeseen global shocks could have a destabilizing effect on the economy and, consequently, on the stock markets as well.

In the meanwhile, Indian stock markets after opening the day on a weak note were trading above the dotted line. At the time of writing, the benchmark BSE Sensex was up by 16 points (+0.1%). The sectoral indices were trading mixed with stocks in the metal and FMCG space being the biggest gainers. However, the stocks in the software and oil and gas space were leading the losses. The Asian stock markets were trading mixed with Indonesia and Japan leading the pack of gainers and Taiwan and Singapore leading the losses. The European indices opened the day on a mixed note as well.

04:50  Today's investing mantra
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2 Responses to "Should you invest in inflation indexed bonds?"


Mar 19, 2014

I am not very clear on how the Inflation Indexed bonds work.
1) Do they pay out 1.5% every year, with the rest of the interest (meaning at the inflation rate) being added back to the principal?
2) What are the tax implications? At the end of 10 years, how are the redemption proceeds taxed? Can we claim all the increase over redemption as capital gains and claim indexation benefit?

Can anyone clarify these two doubts?



Mar 19, 2014

People have lost interest or faith in any Government Scheme - whether it is NPS, Index Bonds or newly introduced PSU ETF. All these schemes are in favour of the Govt. and not for the investors. Actually they have deceived the investors.

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