Inflation can quietly erode the value of your savings, bit by bit, over time. You might even get interest on your investments, but that’s cold comfort if rising prices just eat away at the real value of your returns.
Inflation-indexed bonds were invented to help tackle this problem. These government bonds link their return – whether that’s the original amount you lend or the interest you receive – to an inflation index. This is supposed to help you keep your purchasing power intact even when prices are going up.
In India, the story of inflation-indexed bonds is a bit of a complicated one. The government brought them in to help people manage the risk of inflation, but then stopped issuing new bonds dedicated specifically to this purpose back in 2014.
Now let’s take a closer look at how these bonds work, what they have to offer, what the downsides are, and what other options you have available today.
What Are Inflation-Indexed Bonds?
Inflation-indexed bonds – or IIBs for short – are special debt loans issued by governments where the value is tied to the performance of a particular inflation index, like the Consumer Price Index.
When you buy a bond, you’re essentially lending money to the issuer in the expectation that they’ll pay you back with interest. The bond is a promise that says you’ll get back your original amount plus a bit extra – that’s the interest – at the end of the agreed term.
Unlike a standard fixed-rate bond, inflation-indexed bonds adjust the amount of interest you get, or even the original amount itself, to match any changes in the inflation index. This is meant to help you out if prices start rising, by giving you a bit more money to keep pace.
But here’s the thing – whether you do get real protection from inflation depends on a whole bunch of factors including the bond’s terms, how it’s indexed, and then there’s tax to consider too.
How Do Inflation-Indexed Bonds Work?
When it comes to inflation-indexed bonds, they use an inflation index to work out what adjustments need to be made to the principal amount. Now, the coupon rate is usually fixed, but the amount of interest you get may change depending on how that rate applies to a new, inflation adjusted amount.
Consider this simplified example:
| Particulars | Amount |
|---|---|
| Initial investment | ₹10,000 |
| Assumed inflation adjustment | 5% |
| Adjusted principal | ₹10,500 |
| Illustrative annual coupon rate | 2% |
| Annual interest on adjusted principal | ₹210 |
In this example, a 5% adjustment increases the principal from ₹10,000 to ₹10,500. If the bond calculates interest on the adjusted principal, a 2% coupon would produce ₹210 in annual interest.
These figures are illustrative, not the terms of a currently available Indian bond. Actual payments depend on the instrument’s rules.
The main objective is to help the investment keep pace with inflation. However, inflation protection does not automatically guarantee a positive return after taxes and other costs.
Inflation-Indexed Bonds in India
India has been experimenting with different types of inflation-linked government securities.
Capital Indexed Bonds – A First Attempt at Inflation Protection
India introduced Capital Indexed Bonds back in 1997. The idea behind these bonds was to protect the principal from inflation at maturity. But the way they worked was a bit different from the inflation-linked bonds that came later – particularly when it came to calculating interest payments.
Inflation Indexed Bonds – A New Model
Two years shy of a decade later, The Reserve Bank of India came up with a new version of the bonds in 2013. Now the principal – and interest payments – would be adjusted according to the relevant inflation index.
The first iterations used the Wholesale Price Index (WPI), but later models started to use consumer price indexes instead. However despite these efforts the bonds still struggled to attract much demand. Part of the problem was that the secondary market for these bonds was pretty thin – there just wasn’t a lot of buyers and sellers out there who were interested in trading them.
Availability – Are They Still Being Issued?
According to some reports the government has essentially stopped issuing new inflation-indexed bonds – at least anything thats specifically dedicated to inflation-indexed bonds. So before you go looking to invest you might want to check in with the latest official word on whether any new issues are being made available.
The Benefits of Inflation Indexed Bonds
Inflation-indexed bonds offer a few pretty big advantages.
- Protecting Your Purchasing Power: The main benefit is probably the fact that they help you hold onto your purchasing power – even as inflation starts to rise, these bonds help keep you ahead. Because they’re indexed to inflation, you can avoid losing out to rising prices.
- Higher Interest Payments – Possibly: Depending on how the bond is structured and which inflation index is being used, you might actually end up with higher interest payments over time. This can be a real benefit, but it all depends on the specifics of the bond.
- Government Backing: The real nice thing about sovereign inflation-indexed bonds is that they’re backed by the government – that reduces the risk of default compared to investing in corporate bonds. But keep in mind that there are still market risks involved.
- Planning for the Future: One of the things that inflation-indexed bonds can do is help you plan for costs that you know are going to rise in the future – education, healthcare, retirement. These bonds can give you a bit of a safety net in these kinds of situations.
But they shouldn’t be seen as a complete solution. You still need to assess them against other investments to get the best results.
Read Also: How does Inflation affect your Investment Portfolio?
The Risks and Limitations of Inflation Indexed Bonds
Even with all the benefits they offer, inflation-indexed bonds still come with some risks and limitations.
- Finding One to Invest In: Unfortunately fresh issuance of new Indian sovereign IIBs has been put on hold, so you may not find any new bonds to buy.
- Selling One – If You Need To: If you do end up buying a bond, selling it quickly might be tough because the secondary market is pretty thin.
- Interest Rates: When interest rates rise, bond prices can fall – that might leave you with a loss if you sell before the bond matures.
- Index Issues: The inflation index used by the bond mightn’t actually reflect the rise in prices that you’re most concerned about – for example if you’re worried about education costs.
- Taxes: Keep in mind that tax on interest and gains can cut into your return – the specifics of how it works will depend on current tax law and the instrument itself.
- Opportunity Cost: There are other investments out there that might do better in different economic conditions.
So before you invest you should take a close look at the bond’s terms, how it indexes to inflation, and how easy it is to sell if you need to.
Inflation-Indexed Bonds vs Regular Bonds
| Feature | Inflation-Indexed Bonds | Regular Fixed-Rate Bonds |
|---|---|---|
| Principal | Adjusted according to the bond’s terms | Usually remains at face value |
| Interest | May be calculated on adjusted principal | Usually based on the stated principal |
| Inflation protection | Designed to reduce inflation risk | No direct inflation adjustment |
| Income predictability | Payments may vary with indexation | Interest is generally more predictable |
| Main risks | Liquidity, market and index-related risks | Inflation, interest-rate and liquidity risks |
The right option depends on your financial goals. Regular bonds may suit investors who prioritise predictable interest payments. Inflation-linked securities may be useful when protecting purchasing power is a priority, provided suitable instruments are available.
Alternatives to Inflation-Indexed Bonds in India
Since dedicated sovereign inflation-indexed bonds aren’t currently in circulation, investors are left to explore other options that fit their risk comfort level and time frame.
- Government Securities (G Secs): These are government-issued debt instruments that pay out interest payments and principal repayment as per the agreed terms.
- RBI Floating Rate Savings Bonds: These ones pay out interest at a rate that gets reset periodically, not directly linked to the CPI inflation rate.
- Treasury bills: Essentially short-term government securities – they might be okay for investors who are in and out quickly.
- Debt mutual funds: They invest in various debt instruments, but that comes with the risk of market movements, interest rates & credit quality.
- Gold ETFs: While they provide a way to get in on the domestic gold price, keep in mind that gold prices can be all over the place and won’t necessarily protect you from inflation.
- Equity mutual funds: If you’re looking to play the long game, these might offer some growth potential, but they do come with a lot of market risk – including the risk of losing big in the short term.
These alternatives aren’t an exact substitute for inflation-indexed bonds. Before you make a decision, weigh up the pros and cons of each in terms of risk, cost, liquidity, tax implications & investment period.
How to Buy Bonds using the Pocketful App
Pocketful does give you access to a range of bond investment options, including government and corporate bonds. However, the availability of any given bond is usually a matter of what’s currently listed – dedicated inflation-indexed bonds are less likely to be on offer.
To grab some bonds through Pocketful:
- Open up the Pocketful app: Sign in to your account – or get an account going if you’re new to the platform.
- Head on over to the Bonds section: Check out the bonds that are currently up for grabs on the platform.
- Compare the bond details: Look at the issuer, credit rating, yield to maturity (YTM), coupon rate, maturity date and the minimum amount you need to invest.
- Check the bond’s structure: If you are specifically after inflation-indexed bonds, make sure to double-check that the bond you’re interested in has actual inflation-linked principal or interest adjustments built in – standard government bonds won’t have this automatically.
- Review the risks and costs: Think about the potential liquidity, the odds of the bond price changing before it matures, tax implications, and any applicable fees.
- Complete the investment: If you’re happy with the bond and it’s available to buy, follow the app’s instructions to review and confirm your order.
Read Also: Types of Bonds in India
Conclusion
Inflation-indexed bonds were designed to let you keep your purchasing power safe by linking principal or interest payments to the level of inflation – it’s an idea that’s been around for a while now – with Capital Indexed Bonds coming out back in 1997 and the introduction of IIBs in 2013.
However, the fresh issuance of dedicated sovereign IIBs came to a halt after 2014 – so if you are after this sort of thing, you’ll need to check the current market to see what else is available.
Before you go splashing your cash on any fixed-income investment, think about what you’re getting in terms of return, tax implications, liquidity and risk – the best option is the one that aligns with your goals & time frame.
Frequently Asked Questions (FAQs)
Are inflation-indexed bonds available in India?
To be honest, fresh issuance of exclusive sovereign inflation-indexed bonds has been on ice since 2014 – so, keep an eye on official announcements from the government and RBI for any updates on whether they’re going to become available again.
Are inflation-indexed bonds risk-free?
No investment is entirely risk-free. Government backing can reduce credit risk, but liquidity, interest-rate, index-related and tax risks may remain.
Can I buy inflation-indexed bonds through Pocketful?
Pocketful offers bond investment options. However, you should check the current listings to confirm whether a specific inflation-indexed bond is available. Other government bonds do not necessarily provide inflation protection.
How do inflation-indexed bonds work?
Such bonds have principal and interest payments that vary with an inflation index; It provides a hedge against inflation, as prices rise, but actual returns will vary based on the bond terms and taxes imposed.
