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Will Indians invest in inflation-indexed bonds?

For investors to consider these bonds as a viable investment option, the government will have to put in a great deal of effort in creating awareness.

twitter-logoShweta Punj | December 24, 2013 | Updated 14:08 IST
Will Indians invest in inflation-indexed bonds?

As consumer price inflation rises to a nine-month high of 11.24 per cent in November and deposit rates remain unchanged, the Reserve Bank of India (RBI) has offered a hedging option to investors to offset the brunt of inflation that is eating into gains on investments.

RBI Governor Raghuram Rajan announced in the policy review that the central bank will launch CPI-indexed savings certificates by the end of the year. The interest rate will be 1.5 per cent above the annual average CPI rate.

WHAT ARE INFLATION-INDEXED CERTIFICATES OR BONDS?

They are investment instruments where the principal is indexed to inflation. These instruments are specifically designed to cut the inflation risk.

Traditionally, in uncertain times, gold was considered the safest investment option - a liquid asset which promised better returns than most instruments.

As India's policies started faltering, investors started flocking to gold. This gold rush has added to India's burgeoning current account deficit (CAD). That has had a snowballing effect, which has exposed India's weak macro fundamentals.

Now, to wean Indians away from investing in gold and to restore investor confidence, the government has introduced inflation-indexed bonds.

*Puneet Chaddha, CEO HSBC Global Asset Management, India, says, "Inflation-indexed bonds are quite attractive as a concept. However, the current structure makes it a negative real return product because of the tax incidence. The product looks attractive only for retail investors who are in the lowest tax bracket. The lock-in can be constraining for investors who need liquidity."

HOW THEY WILL WORK

There will be two parts in the interest rate-consumer price inflation rate and a fixed rate of 1.5% per annum. The interest would be compounded every six month. For example, if inflation rate during the six months is 6%, then interest rate for this six months would be 6.75% (fixed rate of 0.75% calculated on a semi-annual basis and inflation rate of 6%).

The 1.5% fixed rate would also be the floor rate, which means that even if inflation turns negative, investors will earn at least 1.5%.

The tenure of these bonds will be 10 years and they will be available at all nationalised banks, HDFC Bank, ICICI Bank and ICICI Bank and Stock Holding Corporation of India.

The minimum investment is Rs 5,000 and the maximum is Rs 5 lakh per applicant per annum.

Premature redemption is allowed for senior citizens (above 65 years) after one year. For others, it is allowed only after three years. In case of premature redemption, a penalty of half the last payable interest will be charged. These bonds can be charged as a collateral for loans.

The interest earned will be added to the income and taxed.


WILL THEY WORK?

Yes, they could, say experts. Inflation-indexed bonds are an alternative inflation-hedged investment option. But, for investors to consider these bonds as a viable investment option, the government will have to put in a great deal of effort in creating awareness.

Demand would depend a lot on factors like the exit process - investors want exit to be as easy as putting money in a bank and if these bonds are being traded on an exchange. There is still a lot of ambiguity and ignorance surrounding how the bonds will work.

"I am sure retail investors would be able to understand what an inflation-indexed bond is, especially investors in rural and semi-urban areas where gold consumption is still very high," says Lakshmi Iyer, Head of Products and Fixed Income at Kotak Mutual Fund.

If inflation eases to 6 or 7 per cent, a fixed deposit would give better returns than an inflation-indexed bond.

"These bonds could attract fixed-deposit investors (if the coupon rate is good) as they would be backed by sovereign guarantee," says Kishore Narne, Associate Director and Head of Commodity and Currency at Motilal Oswal Commodity Broker.

According to the RBI's annual report, Indians invested less in gold in 2012/13 than in the previous year. Investments in gold fell to 2 per cent of gross domestic product from 2.4 per cent. But, this was primarily driven by curbs on gold imports and not so much by alternate investment options.

With added inputs from Team Money Today
* The story has been updated with fresh inputs

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