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Fixed Income

Do Inflation Indexed Bonds Meet Their Objective? Guest Post by Dheeraj Singh

This is a guest post by Dheeraj Singh.Dheeraj is a former fund manager for many years specializing in fixed income. Used to head fixed income at IL&FS Mutual Fund (before it got taken over by UTI) and subsequently worked with Sundaram BNP Paribas Mutual Fund (now Sundaram Mutual Fund) heading the fixed income desk. He runs Finanzlab Advisors, a treasury and risk management consultancy.

So, you’ve heard about the issuance of inflation indexed bonds (IIBs). The first such issuance happens today for a relatively small amount of 2000 crores, when RBI issues inflation indexed government bonds maturing in 10 years

Deepak has written in the past on this to explain the instrument and how it works. This piece does not intend to revisit those. Just to refresh memory, the instrument involves

  • Determining a base coupon rate (through an auction)
  • Indexing the principal once every six months to a higher value (depending on the inflation rate)
  • Applying the base coupon to the higher indexed principal (as a means to provide returns in excess of inflation protection provided by principal indexation explained below).
  • Paying out the indexed coupon every six months.
  • Redeem the higher of indexed principal or original principal on maturity (as a means to provide protection against inflation).

With this structure, inflation protection is achieved by indexing the principal higher. The indexed coupon rate provides the real rate of return in excess of the inflation.

The purpose here is to analyze whether the issuance of inflation indexed bonds in its current form meets the stated objectives. If not, is there a better structure that can meet the objectives more efficiently.

The (Stated) Objective

Let’s begin with the (stated) objectives for the issuance of these bonds.

RBI’s press release of May 15 announcing the issuance of these IIBs begins with the following statement

“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)”.

Ok. So the objectives are:

1. Introduce instruments that will protect saving of poor and middle classes from inflation;

2. Incentivise the household sector to save in financial instruments and move away from buying gold.

The final phrase in the above statement also mentions that RBI has decided to launch the IIBs in consultation with the government (as opposed to the government deciding to launch in consultation with RBI). This statement seems to have special import – as we will see in a moment.

Back to the objectives – let’s see if the proposed design of the IIBs meets them:

Protecting the savings of the poor and middle class requires that they earn an absolute positive real rate of return. In other words investors need to earn an absolute rate of return over higher than the absolute inflation rate.

Cajoling investors to move away from gold is a subject that I doubt any of us has a control on. It can happen only over a long term and requires that gold underperforms other asset classes. It is doubtful that introduction of an instrument like the IIB will cause a major dent in the demand for gold.

So it’s just one objective that is realistically addressed by these bonds – that of proving a return in excess of inflation.

The design of the instrument is such that inflation protection is provided by the principal (since it is indexed higher on a periodic basis – which in this case is 6 months – based on inflation). The return in excess of inflation (which actually provides the positive real rate of return) is provided by the coupon rate.

Given this design, the coupon rate is likely to be low. For e.g. if the market expects the average inflation rate to be 5% over the next 10 years and the current 10 year bond yield (for non inflation indexed bonds) is 7.25%, we can expect the coupon to be about 2.25% – which is nothing but the difference between the 10 year yield on the normal bond (which has some inflation expectation built in implicitly) and the likely inflation expectation.

The coupon on the inflation indexed bond has to be low because inflation expectations are explicitly built in (through principal indexation) as opposed to being implicit (as in normal fixed rate bonds). Else, there would be distortions in the yield curve which would quickly be bridged by arbitragers.

Given that the inflation protection is provided by principal indexation – it can only be realized in two ways

a) On maturity – when the government pays out the cumulative indexed principal

b) In the secondary market – wherein the market is expected to price in the higher indexed principal.

If one does not hold to maturity or if one wants to realize or book the inflation protected returns, the only way to achieve it would be through a secondary market sale. This presupposes the existence of an active secondary market and ease of dealing in the secondary market that makes such a thing possible. Given the current state of affairs on trading in government securities for retail investors this does not inspire much confidence.

Is there a better way?

So, is there a way in which retail investors can be compensated for higher inflation without they having to go through the rigmarole of the secondary market. The simple answer is, Yes, there is.

The Alternative: A simple floating rate bond structure which has

  • No principal indexation; and
  • A floating coupon rate which is a sum of the inflation rate plus a spread over and above the inflation rate.

would meet the objectives of providing and inflation protected return to retail investors in a simpler and more transparent manner.

The advantage here is that inflation protection as well as the positive return over the inflation is in built within the coupon instead of being distributed over the principal and coupon. Since the coupon is paid out once in six months the investor realizes both inflation protection as well as a small excess return (given by the spread) every six months. This structure is likely to find more takers amongst the “poor and middle class” and is also likely to meet the stated objectives better.

Which brings us to the final question – Who benefits most from the current structure?

If designing a simple floating rate bond to meet objective of inflation protection is so simple – why haven’t our policy makers who have far greater intelligence and are well aware of the limitations of our secondary markets not take this route to design the instrument.

The hint to this answer probably lies in the last phrase of the RBI statement I highlighted above, that – it was RBI which decided to launch the bond in consultation with the Govt and not the other way round.

What do I mean by this?

It is more in the interest of RBI than anybody else to have a market in IIBs as they have been designed currently.

One of the challenges that RBI faces in managing monetary policy is that it has to gauge inflation expectations from the yield curve. Since normal bonds have embedded inflation expectations implicitly, policymakers have to tease out and separate inflation expectations from the other myriad factors that go into bond yields.

Having an instrument like the inflation indexed bond which builds in inflation protection explicitly (rather than implicitly) makes the policymakers task that much easier. A look at the yield curve for the inflation indexed bonds gives RBI and other policymakers a better grip on the market expectations for inflation than any other instrument can.

It is my contention that the inflation indexed bonds is likely to be more useful to policymakers and other analysts in gauging inflation expectations than it is to help “poor and middle class” investors earn an inflation protected return.

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  • pattu says:

    Hi Dheeraj,
    Nice analysis. The implications are worrying. I was recently talking to someone related to NPS about the possibility of an inflation indexed annuity in NPS.
    He has said issuing inflation indexed bonds now is the first step towards that!
    Have no idea what this means or if this is true. Any thoughts?

  • Dheeraj says:

    Pattu,
    Inflation indexed annuity (on retirement) is a good option to have.
    Inflation indexed bonds would help in achieving that, but I doubt if that is an objective of the current exercise.
    To me, it looks like they’re testing waters to come up with an optimal structure. However, as i say in my post, the current structure of the instrument (which is an exact copy of the structure prevalent in the US, by the way) is suited more to the requirements of policymakers (principally RBI) than the “poor and middle class”. However, they’d want us to believe otherwise.
    I’m willing to give some benefit of doubt to RBI here. They’ve said that they’ll fine tune the instrument based on the response to the initial auctions. Let’s see how this goes.

    • pattu says:

      Thanks for your response.
      Are such bonds recommended by fin. planners in the US?
      I am curious to know the technical aspects of how issuing such bonds will help provide inflation indexed annuity. Can you point me to a source reg. this? Thanks again.

      • Dheeraj says:

        I’m not an expert on financial planning in the US. So, wouldnt know if this is something they recommend or not recommend.
        However, I do have ideas on how this can be used to structure an inflation indexed annuity and also how it relates / does not relate to NPS.
        In the interest of keeping discussions brief and focused would prefer to take it offline though.
        Touch base with me at dheeraj / dheerajsingh dot com and we can discus further.

  • Annapurna says:

    Very useful info. But, if the coupon rate is this low, these inflation indexed bonds hardly make sense. Why not invest in the dynamic long term bond funds or the long term floating rate funds which have a good track record and are tax efficient too? Even these may be able to generate a real rate of return on par with the inflation indexed bonds.

  • fubar says:

    Inflation indexed bonds will never be issued in enough quantity to make a dent anywhere. If implemented honestly, that will be like bringing the gold standard back.