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IIBs and the common person - Outside View by S.S. TARAPORE
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IIBs and the common person
Jun 3, 2013

Nothing devastates the common person more than inflation. With consumer price inflation reaching double digits, the household sector is moving from financial savings to savings in physical assets, including gold.

Rationale for Inflation Indexed Bonds

In the union budget for 2013-14, it was indicated that savings instruments would be introduced to protect savings from the adverse effects of inflation, especially for the poor and middle classes. In accord with this laudatory objective, one would have expected that the Inflation Indexed Bonds (IIBs) would be available as a separate instrument for individuals. The IIBs, have been issued as part of the government's regular borrowing programme, which is normally subscribed to by banks and other institutional investors. This is being done for what, in bond market jargon, is called 'price discovery' i.e. the determination of the appropriate rate of interest to be paid on these bonds.

Features of the IIBs

During 2013-14, it is intended to issue Rs 12,000-15,000 crore of IIBs. The first tranche will be auctioned on June 4, 2013, for an amount of Rs 1,000 crore and would be open to institutional investors, viz. banks, Pension funds, insurance companies and mutual funds of interest. The IIBs will have a real rate of interest, which will be determined at the auctions and will provide for full protection of the capital, but only partial protection on the interest.

The inflation index for the IIBs will be the Wholesale Price Index (WPI), rather than the Consumer Price Index (CPI). Let us say that that the principal amount invested is Rs 100 and the WPI at the inception of the IIBs is 100. If, in the first year, the WPI rises by 6 per cent, to 106, the Inflation Adjusted Principal will be increased to Rs 106. Assuming that the real coupon rate is 1.5 per cent, the investor will get an interest of 106/100x1.5= Rs 1.59.Now, if by the tenth year, the cumulative inflation is 60 per cent, on maturity the investor will get back Rs 160. In the tenth year, the coupon payment will be 160/100x1.5= Rs 2.40.

Individuals participating in the auctions

In the normal auctions for government securities, five per cent is kept reserved for investors (including individuals), who can make a 'non-competitive bid' i.e. they merely set out the amount they wish to invest and the pricing emanates from the auction. In case of the IIB, the non-competitive portion has been enhanced to 20 per cent. Given the uncertainties and as no benchmark has emerged, it is unlikely that the 'non-competitive' bids will amount to 20 per cent of the amount auctioned.

Implications for the common person

There are some issues which the common person has to bear in mind.

(i)The maturity of the IIB will be 10 years and, therefore, not suitable for senior citizens, who are dependent on interest income for their day to day expenditures.

(ii)Investors would get a substantially larger amount on maturity, as compared with the capital invested, but the interest earned each year would be substantially lower than the nominal interest earned on bank deposits. As such, individuals dependent on interest income will find this instrument unsuitable.

(iii) The crucial determinant is the real coupon rate. It will necessarily be lower than the nominal rate of interest on bank fixed deposits. In the Frequently Asked Questions (FAQs) put out by the RBI, the illustration is based on a 1.5 per cent real rate of interest. While the eventual coupon rate is anyone's guess, it will probably settle in the range of 1.5 -3.0 per cent.

Pointers for the common person

First, the maturity of the IIB of 10 years is far too long and if the common person is the target group, the maturity should be five years.

Secondly, retail investors participating in the first tranche would be playing their cards blind, as they would be 'non-competitive' bidders. Hence, retail investors would be well advised to stay away from the first auction of the IIBs.

Thirdly, retail investors should wait for the October 2013 tranche, which would be exclusively for retail investors. This tranche would, hopefully, have a shorter maturity, say five years, and have a fixed coupon rate and investors would be able to take a call on whether they would wish to invest in this instrument.

Fourthly, while the IIB is portrayed as being an alternative to gold, it is really not a substitute. If, at all, it would compete to some extent with bank deposits. Here again, investors would be well advised to stay with bank deposits, as they generate larger annual streams of income, while the IIB would be more in the nature of a capital gain; even at a 3 per cent real rate of interest, the interest plus capital gain would together be lower than the income stream from the nominal interest rate on bank deposits.

Fifthly, from the investor viewpoint, the CPI would be preferable to the WPI. It is pertinent that while assessing capital gains, the CPI is used as also for the payment of Dearness Allowance and there is no reason not to use the CPI for the IIB.

Sixthly, to provide effective competition to gold, the IIB would need to be revamped. The real coupon rate could be kept low, say 2.0 per cent, but to this should be added the annual CPI inflation rate. Illustratively, if the CPI inflation is 9.5 per cent, the inflation adjusted interest rate should be 2.0+9.5=11.5 per cent. As the inflation rate comes down, the interest rate paid would come down commensurately. Of course, the principal amount would need to be indexed on the maturity amount paid back. Such an instrument would appear costly, but if the government is serious in its intent to curb inflation, the cost would be moderate. More importantly, it would give gold serious competition and have a salutary impact on the macroeconomic balance.

Concluding Message

Retail investors would do well to totally eschew from investing in the first tranche of the IIB. (Syndicated)

Please Note: This article was first published in The Free Press Journal on June 03, 2013. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.


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