Economists would tell you that the inflation monster must be tamed if you have to reap high return on your investments. The connection between inflation and the future value of your money, however, is not so straight always. Take the case of inflation index bonds (IIBs) linked to consumer price inflation that yield higher returns for investors in times of high retail inflation. In other words, the higher the CPI in future, the greater would be the ROI.
IIBs linked to consumer price inflation or CPI were announced in the Union Budget 2013-14 and launched on December 23 last year for subscription until December 31, 2013. In the beginning, when these bonds were launched last year, they were linked with wholesale price index (WPI) but because of poor investor response IIBs linked to CPI were launched in December. The RBI has now extended the subscription date for these bonds until March 31, 2014
The purpose is to incentivize household savings, and more importantly, to wean millions of Indians away from buying gold whose dollar-denominated import has been a drain on India’s fiscal causing its current account deficit to balloon. Apart from emotions attached with gold and being a safe haven asset, a plausible reason why gold has continued to enamor Indians for years is the limited choice of financial instruments and other productive investment avenues that could provide hedge against inflation.
A survey conducted by the National Council of Applied Economic Research in 2011 indicated that among all the households in India, less than 11% are investment household and the rest are savers household which have nil exposure to equities, derivatives, mutual funds, debentures, government bonds and corporate bonds. In order to promote investment as opposed to just saving, IIBs, also called Inflation Indexed National Savings Securities-Cumulative (IINSS-C) for retail investors was launched. The aim was to provide an investment avenue to risk-averse Indian households for parking their hard-earned money that could not only beat the inflation monster but carries minimal risk and volatility like the precious metal.
So can CPI-linked IIBs win the hearts and minds of investors? Let’s first understand how IIBs provide hedge against high inflation.
Designed To Appeal
The maturity of these bonds is 10 years and the coupon paid is, as the name suggests, linked to consumer price inflation. For instance, if December CPI was 9.87% the interest rate on these bonds will be the same, i.e. 9.87 (or 10% after rounding off). What’s interesting is that apart from the CPI rate these bonds would pay an additional fixed interest rate of 1.5% per annum.
Both the components of compounded interest rates (i.e. interest rate equivalent to CPI + 1.5% coupon) will be added in the principal on a half-yearly basis and paid along with principal at the time of maturity, thus providing compounding benefits (See Investment Map).
Another crucial point is that the bond would take the three months earlier CPI figure to calculate interest. The coupon rates are payable by keeping March and September combined CPI figures as benchmarks and paid at six month duration in June and December only. This means if the February CPI is 8% but it slips 100 basis points in March to 7%, your yield would factor in 7% and not 8% as the interest rate.
Buying these bonds is easy. Just contact any authorized bank (that includes SBI and its associates, any nationalized bank, HDFC Bank, ICICI Bank, and Axis Bank) and Stock Holding Corporation of India and you can invest through them. You can start investing in this instrument by a minimum amount of Rs 5,000 and the maximum you can invest is Rs 5 lakh. However, the post-tax returns of IIBs vary as per the tax slab of the retail investor. The post-tax returns for taxpayers in the lowest tax bracket are much higher than for investors in the higher tax slabs, making it not so attractive investment for high-earners.
As Manoj Nagpal, CEO, Outlook Asia Capital, Mumbai, says, “These bonds are targeted to the retail investors ideally in the tax bracket of 10% and 20% with a limit on maximum investment of Rs 5 lakh per financial year. Effectively these bonds provide an excellent hedge to inflation both in terms of pre-tax and post-tax returns to this category of investors.”
Let’s assume after 10 years these bonds give 11.5% return pre-tax return (9.5% CPI+1.5%) while the annual inflation remains 10%. For an investor in the highest tax slab (30%, effective 30.9%) the post tax return would be the lowest, i.e. 7.94%; for investor in the 20% (effective 20.6%) tax slab, the returns would be 9.13%; while for the lowest tax slab investor 10% (10.3% effective) the returns would be highest at 10.31%. Compare it with the returns of a 10-year FD that offers 9% interest. Post tax, the returns for the highest tax payer would be 6.21%; for taxpayers in 20.6% bracket it would be 7.14%, while it would be 8.03% for taxpayer in 10.3% bracket, much less than the retail inflation.
Downsides Outweigh Benefits
Notwithstanding the zero credit risk and default risk (as these bonds are backed by the sovereign) and inflation beating returns that these bonds are capable of giving especially for lowest tax slab investors, there are a few downsides that retail investors should be careful about while investing in this instrument. The first drawback is that since these bonds are linked to CPI, returns from these bonds would be negatively impacted if retail inflation comes down in the future.
For instance, imagine if the CPI inflation rate goes in the negative territory sometime in the future, then in such case these bonds would not factor in negative inflation and instead pay only the fixed coupon rate of 1.5%, thus bringing down cumulative returns on your investment. In short, you would want retail inflation to remain reasonably high that would enable you to reap higher benefits.
The second drawback is the somewhat illiquid nature of this instrument. Although premature redemption is allowed, you can withdraw only after three years unless you’re a senior citizen where premature redemption is allowed after one year. Because of this lock-in provision, experts advise investors not to allocate more than 20% of the overall investment allocation in debt in these bonds.
“As there is minimum lock-in of 3 years for these bonds it will be advisable not to exceed 20% of an investors' debt portfolio allocation to the bonds keeping in mind the ability of the investor to lock-in the investments and also keeping in mind the floating nature of the interest income, maintains Nagpal of Outlook Asia Capital. That there is only a cumulative option is a drawback and hence the bonds will only serve the purpose of accumulation of income and will not be suitable for investor's seeking regular income, he adds.
In case of early withdrawal that is allowed only on coupon dates, you would have to shell out penalty at the rate of 50% of the last coupon payable, which experts say is a big dampener. For example, if last payable coupon is Rs 500, then Rs 250 would be charged as penalty and deducted from the matured amount.
“The redemption rules are negative as also the maximum amount - Rs 5 lakh, which can be invested. The regulations will need to adapt and change as the economic environment improves,” adds Brijesh Damodaran, Founder and Managing Partner, Zeus WealthWays, a wealth management firm. The third drawback relates to its tax treatment. Interest on CPI-linked bonds is taxable as per the tax slab the bonds holder falls in.
No doubt, CPI-linked IIBs have potential to promote investment. But the returns are taxable and the post-tax returns are tilted more in favor of lower tax slab investors. Moreover, the instrument should be aggressively marketed. Otherwise, IIBs could end up as being just one among several investment products that have yet to win over the faith of millions of middle and low-middle class Indians through their product offerings.
The jury is still out on whether IIBs can win back investor confidence.