Inflation-indexed bonds are often seen in the news. Do you know what exactly it is? Read to know more about Inflation-indexed bonds.
Did you ever think about saving a part of your income? Probably the first thing which came to our mind will be of savings account or buying a bond. However year by year there is an overall rise in prices which reduces our purchasing power over time. This is due to inflation. Here comes the role of inflation-indexed bonds.
When the principal amount of a bond is indexed to inflation, it is called an inflation-indexed bond. Indexed to inflation means the principal amount rises or falls with the rate of inflation. Regardless of the amount of inflation in the economy, the investor is guaranteed a continuous return.
How is interest on an Inflation-indexed bond calculated?
- Principal amount – the amount invested.
- Adjusted principal – (Inflation index at a given point of time)/(Inflation index at the time of deposit) × principal amount.
- Interest being paid – adjusted principal × coupon rate.
For example:- Let the principal amount of a bond be Rs.100 sold at a coupon rate of 5%. If inflation rises by 10%, in the case of a fixed deposit investor will receive Rs.5 per year as interest while in an inflation-indexed bond, the principal amount will get adjusted to Rs.110. Hence the resulting interest payment will be Rs.110 × 5% i.e. Rs. 5.5. At the time of redemption, adjusted principal or face, whichever is higher will be paid.
Features of inflation-indexed bonds:
- Coupons will be paid on half yearly basis. The fixed coupon rate will be paid on an adjusted principal.
- IIBs are issued for 10 years.
- As they are G-secs, eligible for SLR status.
- The main objective is to protect middle the poor and middle classes’ savings against inflation.
- The minimum amount of investment is Rs. 5000 and the maximum limit is Rs. 10 lakh per annum for individual investors and Rs. 25 lakh per annum for institutions.
Inflation-indexed bond was first issued by Massachusetts Bay Company during the American Revolution to combat inflation’s effects on the price of consumer goods in the colonies during the war.
In India, IIBs were announced in the 2013 budget mainly to provide an alternative for the household to invest in rather than gold as the increasing current account deficit (CAD) driven by higher gold imports is of serious concern. Until 2013, capital-indexed bonds were issued which will protect only the principal, unlike IIBs which can provide inflation protection for interest payments as well.
Currently, IIBs are linked to WPI, not to CPI. Why?
Because in India CPI is being released since January 2011 and will take some time to stabilize. Also, monetary policy is being continued to target WPI for its price stability objective.
Globally CPI is used for inflation targets by central banks as CPI reflects the inflation faced by the majority.
- Tax provisions are applicable on interest payments and capital gains made when sold in the secondary market (through the BSE, NSE, and other stock exchanges).
- There will be no special tax treatment for these bonds.
United States, India, Canada, and many other countries now issue Inflation-indexed bonds. There will be a rising demand in the coming future as these bonds can hedge the inflation risks and hence protect the capital amount of the investor.
Previous Year UPSC Questions from the topic
Read the question (Prelims 2022) given below:
With reference to the Indian economy, what are the advantages of “Inflation-indexed Bonds (IIBs)”?
- The government can reduce the coupon rates on its borrowing by way of IIBs.
- IIBs provide protection to investors from uncertainty regarding inflation.
- The interest received as well as capital gains on IIBs are not taxable.
Which of the statements given above are correct?
- (a) 1 and 2 only
- (b) 2 and 3 only
- (c) 1 and 3 only
- (d) 1, 2 and 3
Answer – (a)
Article written by: Krishnapriya JR