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Inflation Indexed Bonds
RBI has just released the WPI data for the month of June 2013.This value is 4.86%.But does this value represent the true prices of the month of May 2013. No definitely not?. This may be a reflection of the prices of September 2012 .This data is then interpolated to arrive at an accurate figure for the month of June 2013.A lag is allowed as adjustments due to revision might be necessary as you must have seen on a regular basis in recent years. Let us see how inflation indexed bonds work. We have Mr Rakesh who purchases a 5 year bond of face value INR 100.The coupon rate is 7% per annum. According to this Mr Rakesh should earn INR 107 inclusive of interest every year. Do you think is it fair if the inflation rate has changed or increased to 8% when the coupon rate is just 7%.One now has Inflation Indexed Bonds in order to resolve this shortfall in returns. However if inflation rate falls then you suffer losses on your investment. Now you will be able to understand more clearly about how inflation indexed bonds work with the help of the following calculations.
One notices different values of inflation over a 5 year period. As shown in the table the principle as well as interest amount changes according to the inflation rates.
Year 1: Let us consider that inflation rate is 7% as shown in the table . Initially WPI index was 200 which changed to 214.
Principal = issue time principal * (current WPI / WPI index at issue time).
New Principal = 100*(214/200) = 107.
Interest based on the coupon rate =7% of the new principal =7% of 107=INR 7.49
Year 2: Let us consider that inflation rate is 6% for the following year. So the WPI is 214*106%= 226.84 (6% shown in the table).
New Principal = 100*(226.84/200) = 113.42.
Interest = 7% of the new principal =7% of 113.42=INR 7.9394
In this way one can see the principal and interest goes on increasing and changing as per the inflation rates. If inflation rises as you must have noticed then you will get a higher principal and a higher interest and vice versa.
I would like to end this article with the famous quote " When You Reach The End Of Your Rope Tie A Rope And Hang On ".Never allow inflation to affect your finances and utilise all possible financial instruments to beat inflation.
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