CPI Inflation Linked Bonds

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Experts feel the proposed bonds will take a while to catch on with retail investors just like the WPI-linked bonds IINSS-C bonds would be the perfect inflation hedge, offer better returns and would be safe.  MORE trading activity would improve liquidity which will improve long term interest for IINSS-C

THE Reserve Bank of India (RBI) would be launching the Inflation Indexed National Savings Securities Cumulative (IINSS-C) bonds for the retail investors this month. While the Inflation Indexed Bonds linked to Wholesale Price Index (WPI) has not seen a great response with participation mostly coming from insurance companies and pension funds, experts say that the proposed IINSS-C bonds (inflation bonds linked to the consumer price index) may also take a while to catch on.

According to RBI data, since the launch of the WPI inflation bonds on June 4 upto November 26, the total notified amount for these bonds was Rs 7000 crore while the amount accepted was Rs 6,000 crore. The total amount received by the RBI during this period was Rs 18,681 crore.

While one auction had to be cancelled on July 29, 2013, there were two devolvements -the first on August 27 with bid amount at Rs 532 crore while the second devolvement happened on September 24 with bid amount of Rs 40 crore only.

Although RBI has reserved 20 per cent of the WPI bonds for retail investors, the auctions has seen a very lacklustre response from retail investors due to the fact that the Consumer Price Index (CPI) inflation is much higher than the WPI. The 1.44 per cent 2023 inflation indexed bonds that was first issued in June is currently trading around 3.63 per cent. In the last few auctions of the bond, there were no bids in the noncompetitive segment reserved for retail investors.

Some bankers and fund managers said that in other countries too it took time for the market to develop for inflation indexed bonds and expect a better demand from IINSS-C bonds as these would be indexed to the spending power of individuals. As per the latest October numbers, inflation based on WPI for October was 7 per cent while the CPI inflation figure was 10.09 per cent. The CPI inflation in September was 9.84 per cent. Currently, the gap between the WPI and CPI indices is 3.09 per cent.

NS Venkatesh, treasury head, IDBI Bank said, "I think the response for the WPI linked inflation bonds have been good with the bids to cover ratio of 2.5 times. But the IINSS-C bonds would be the perfect inflation hedge, offer better returns and would be very safe as these would carry government of India security."

It is difficult to gauge the success of an instrument solely from the bid to cover ratio as primary dealers (banks) have to compulsorily underwrite every auction. The demand is not coming from banks but from insurance companies and pension funds.

The yield levels in the WPI-linked inflation bonds were low and mispriced at 1.44 per cent at the time of launch in June but now the yields have corrected and have increased to 3.5 per cent. So the demand has picked up

The government has planned to raise Rs 12,000 to 15,000 crore in FY14 through inflation indexed bonds. The bonds would help correct the macroeconomic imbalances especially the high current account deficit caused by domestic investors widespread use of gold as an inflation hedge. to the fact that the Consumer P Only crude oil accounts for a larger share of India's imports than gold. India this year may import 900 to 1,000 metric tons of gold this year. The World Gold Council report says that India has imported about 560 tons of gold in the first six months of 2013.

According to Moody's Credit Outlook June 10, 2013 issue, "If inflation indexed bonds reduce domestic investor demand for gold as an inflation-hedge asset and reduce gold imports, it would alleviate balance of payments and exchange rate pressures"

"However, any tempering in gold imports in the near term is more likely to come from the recently extended import curbs than from inflation-indexed, which will total Rs 150 billion (Rs 15,000 crore) this year, compared to our estimate of an Rs 3 trillion (Rs 3,00,000 crore) gold import bill," added Moody's.

The RBI had first in 1997 introduced the Infla tion Indexed bonds but its attempt was unsuccessful.

Like India, several emerging markets are turning to inflation-linked bonds recently to raise cash. Philippines plans to introduce such bonds early next year.

According to details provided by RBI, the IINSS-C bonds will earn a fixed interest rate of 1.5 per cent in addition to consumer inflation rate and the same will be compounded in the principal on half-yearly basis and paid cumulatively at the time of redemption. For instance, if CPI is at 10 per cent, the IINSS-C will give you 11.5 per cent returns (10 per cent + 1.5 per cent). The tenure of the IINSS-C would be for 10 years. These bonds will also be eligible as collateral for loans and early redemptions with some riders. The CPI linked bonds would be sold through banks and the final combined CPI will be used as reference CPI with a lag of three months. For example, the final combined CPI for September 2013 will be the reference CPI for all days of December 2013. The minimum investment amount is Rs 5,000 and the maximum of Rs five lakh per applicant per annum would be allowed. The bonds are eligible for early redemptions after one year from the date of issue for senior citizens (above 65 years of age) and 3 years for all others. Penalty will be charged at the rate of 50 per cent of the last coupon payable for early redemption.

In the WPI linked bonds that were launched in June, both principal and interest payments are indexed to WPI with the base year as 2004-05. The reference rate for inflation is taken with a four month lag.

Bankers said the CPI bonds will get a positive response but volumes may take time to pick up given the cap on maximum investment and liquidity issues.

More market participants and more trading activity would improve liquidity which inturn will improve longer term interest for the proposed IINSS-C.

The WPI and CPI linked bonds cannot be compared. IINSS-C bonds would be offered only for individuals and won't be tradable. There is a cap of Rs 5 lakh on the maximum investment amount. So these would be similar to a small savings certificate with a real yield of 1.5 per cent.

Had the government been a little flexible in the design of this product, one could expect a higher demand for the CPI bonds.

So what will the returns be like in CPI-linked bonds?

Unlike investments in Public Provident Fund (PPF) and tax-free bonds where the interest earned is taxfree, in case of IINSS-C the tax treatment on interest and principal repayment would be as per the existing taxation provision.

Assuming that the coupon rate for these bonds in a given year works out to 11.5 per cent, then the post-tax return for the year for someone in the highest tax bracket (30.9 per cent) will be 8.17 per cent. For those in the 20.6 per cent tax bracket, the post-tax return would be 9.39 per cent while for those in the lowest tax of 10.3 per cent would get 10.6 per cent. Individuals in these different tax brackets earning from other taxable (interest and principal redemption) fixed-income instruments such as bank fixed deposits will find CPI-linked inflation bonds attractive only if the gross yield (CPI + 1.5 per cent) is a figure higher than the gross interest rate they are fetching from existing taxable fixed-income investments.

Variability in returns is seen as a key factor in CPIlinked inflation bonds by some financial advisors While in a fixed income instrument your yield is locked, in an inflationlinked bonds, your returns are getting adjusted to inflation. These bonds can be looked at by pensioners or people with low risk taking appetite who would like to cover their expenses.

Post-tax returns from CPI-linked inflation bonds may find it difficult to compete with post-tax returns from PPF if the consumer inflation falls or is at low levels.

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