Thursday, May 30, 2013

Inflation Indexed Bonds

RBI announces Scheme for Inflation Indexed Bonds – 2013-14

For Rs. 12,000-15,000 crore

To be issued in tranches

First tranche on June 4, 2013 for Rs. 1000-2000 crore

1. Pursuant to the announcement made in the Union Budget for 2013-14 to introduce instruments that will protect savings of poor and middle classes from inflation and incentivise household sector to save in financial instruments rather than buy gold, RBI, in consultation with Government of India, has decided to launch Inflation Indexed Bonds (IIBs).

2. For appropriate price discovery and market development, it is however, necessary to issue comparable instruments through auctions to the institutional investors such as Pension Funds, Insurance, and Mutual Funds etc. This will create demand for IIBs and help in making them tradable in the secondary market. It is therefore proposed to issue initial series for all categories of investors including institutional investors and, later, another series, exclusively for retail investors. First series of IIBs would be issued in first half of the current financial year. To target greater retail participation for this series also, it has been decided to enhance the non-competitive segment for retail and mid-segment investors to 20 per cent from the present level of 5 per cent applicable to auction of usual GoI securities.

3. The details for first series of IIBs are as under:

• IIBs will be having a fixed real coupon rate and a nominal principal value that is adjusted against inflation. Periodic coupon payments are paid on adjusted principal. Thus these bonds provide inflation protection to both principal and coupon payment. At maturity, the adjusted principal or the face value, whichever is higher, will be paid.

Index ratio (IR) will be computed by dividing reference index for the settlement date by reference index for issue date (i.e., IR set date = Ref. Inflation Index Set Date / Ref Inflation Index Issue Date).

Final Wholesale Price Inflation (WPI) will be used for providing inflation protection in this product. In case of revision in the base year for WPI series, base splicing method would be used to construct a consistent series for indexation.

Indexation Lag: Final WPI with four months lag will be used, i.e. Sept 2012 and Oct 2012 final WPI will be used as reference WPI for 1st Feb 2013 and 1st March 2013, respectively. The reference WPI for dates between 1st Feb and 1st March 2013 will be computed through interpolation.

Issuance method: These bonds will be issued by auction method.

Retail Participation: Non-competitive portion will be increased from extant 5 per cent to up to 20 per cent of the notified amount in order to encourage participation of retail and other eligible investors.

Maturity: Issuance would target various points of the maturity curve in order to have benchmarks. To begin with, these bonds will be issued for tenor of 10 years.

Issuance Size: Each tranche of IIBs will be for `1,000 - 2000 crore and total issuance would be for about `12,000-15,000 crore in 2013-14.

Issuance Date: First such tranche will be issued on June 4th 2013 and the same would be issued regularly through auctions on the last Tuesday of each subsequent month during 2013-14.

4. Second series of IIBs exclusively for retail investors will be issued in second half of the financial year. First series of the IIBs will help in determining the coupon rate for the bonds through auction. This will help in benchmarking IIBs. Based on the experience in the initial issuances, second series of IIBs for the retail investors is proposed to be issued around October. Terms of issuance of IIBs for retail investors would be announced in due course.

Mr. Gerard Colaco: I have read the RBI circular dated 15th May 2014 about Inflation Indexed Bonds (IIBs). Ordinarily, these bonds would have suited a large number of our clients and we would certainly have collected reasonably big amounts for these bonds.

However, the RBI circular mentioned above conceals more than it reveals. The face value of the bonds is not mentioned. The quantum of minimum application also does not appear in the circular. The coupon rate is not indicated and the circular is silent about taxability of the bonds. In short, the information is quite patchy for bonds that are supposed to be issued in a shade over a fortnight's time.

The worst aspect of these bonds is that inflation indexing will be based upon the wholesale price index (WPI), which in India in my opinion is 10% fact and 90% fiction.

It would have been far better to base it on the Consumer Price Index (CPI), which in my opinion, is at least 50% fact and only 50% fiction in India. It would of course be too much to expect a genuine inflation index which is 90% fact and 10% fiction to ever be put in place in an unfortunate country like India.

A factor of paramount importance is the taxability of the interest on the bonds. If this interest is going to be fully taxable, the bonds become unattractive. If on the other hand, the interest is tax free or in some manner tax efficient, then at least there would be some compensation for WPI-linked indexing instead of CPI-linked indexing.

A starkly depressing contrast would be the Treasury Inflation Protection Securities (TIPS) issued by the Federal Reserve in the US. The bonds are indexed to CPI inflation. CPI is measured after taking into account change in prices of approximately 60,000 items of goods and services. Interest on the bonds is fully taxable. Growth in the value of the bonds is taxable as capital gains.

But TIPS are eligible for investment in various retirement avenues such as Individual Retirement Accounts (IRAs), 401(k) plans and Keogh Plans. In these plans, all income on the bonds is tax deferred, thus providing genuine inflation protection to the holder thereof, instead of the kind of chicanery the Government of India is eminently capable of foisting on its citizens.

Kindly keep us informed if you obtain further information on these instruments.