Inflation erodes purchasing power of money. Hence, there has been an ever increasing need for instruments that provide a hedge against inflation. Inflation indexed bonds (IIBs) are instruments that do this job pretty well. Since, payments of IIBs are linked to inflation they help maintain the purchasing power. IIBs were first launched in India during 1997. And considering the current inflationary scenario Reserve Bank of India (RBI) is all set to re-launch these instruments in the Indian markets. The first tranche of bonds worth Rs 10-20 bn is scheduled to hit the markets on 4th of June, 2013.
First let us understand the basic mechanics of these bonds and its cash flow characteristics. Then we will see whether investing in such bonds provides the necessary hedge against inflation or not.
Since IIBs provide protection against inflation, the first and foremost thing is to decide the relevant inflation measure. The relevant measure for this issue is wholesale price index (WPI) inflation. The base year decided is 2004-05. Second thing to note in such issues is which cash flows are indexed to inflation. Is only the principal indexed, or both principal and coupon are indexed? The upcoming issue will hedge both principal and coupon payments against inflation.
Now let us understand the mechanics with the help of an example. Let's assume the IIBs are issued on 4th June, 2013 at Rs100 (face value) carrying an interest rate of 10% payable annually and have a maturity of 10 years.
On 4th June, 2014 the first interest payment will become due. The interest figure stands at Rs 10. Now let's assume that the relevant inflation over the same period is 8%. And since these bonds are inflation indexed the holder will receive Rs 10 (original coupon payment) * 1.08 (inflation rate) = Rs 10.8 (inflation indexed payment). Considering that the principal was also inflation indexed the Face Value (FV) also increases to Rs 108 (100*1.08).
These indexed payments help individuals maintain their purchasing power. However, not in the strictest sense per se. That's because these bonds are indexed to WPI inflation. And the relevant measure for individuals is the Consumer Price Index (CPI) inflation. To the extent CPI inflation is higher than WPI inflation purchasing power is eroded.
Also, it may be noted that the bond market in India is in nascent stage. And the upcoming IIB issue is one of its kinds. If the issue does not garner enough interest the liquidity of such bonds will be low. Low liquidity means that the investors will have to incur higher impact cost (trading cost) while exiting. This higher cost may offset the indexation benefit to some extent.
Thus, while these bonds are intended to provide the desired inflation hedge we are not sure whether the hedge will really work.