Inflation Indexed Bonds – Features and Benefits

From Indian Economy Notes » Security Market in India

We can understand Inflation-Indexed Bond (IIB) as a constant return to the investor irrespective of the level of inflation in an economy. In other words, we can say that it is basically an instrument that is used to provide a hedge and to safeguard the investor against macroeconomic risks in an economy.

The issue of IIBs has a lot of significance in the Emerging Market and Developing Economies during the recent years because during this period the value of money loses rapidly in an environment of high inflation. Basically, Inflation-Indexed bonds are limited on account of the low inflation experienced in these economies.

This topic of “Inflation Indexed Bonds – Features and Benefits” is important from the perspective of the UPSC IAS Examination, which falls under General Studies Portion.

How IIBs Work?

It is very important to understand the application of this concept. We can understand it better by comparing it with the instrument of fixed deposits with the bank because fixed deposit also offers a fixed rate of interest for the investment for a given number of years but the difference is that it does not protect the investor from the erosion of the real value of the deposit due to inflation. On the other hand, if somebody invests in IIB then it gives a constant minimum real return irrespective of the inflation level in the economy. The capital of the investor will increases with inflation, so actual interest is better than originally promised. Now, let’s understand what happens in the case of Deflation, in such case,  interest payments decrease with the negative inflation. However, this does not affect the capital as it does not decline below the face value.

History Of IIB

One of the major concerns in 2008-2013 was Inflation where real interest rates were consistently negative. This period also was noted for the high current account deficit (CAD), which means that it saw huge investment in the alternate instrument – gold – by the households, necessitating the heavy import of gold. So, the need to reduce the attractiveness of gold for investment and reduce the CAD was felt, and hence the Government of India launched Inflation-indexed bonds (IIB) on 4 June 2013.

The wholesale Price Index which was then used as the key measure of inflation by RBI was auctioned linking to its first tranche. IIB bonds were started to be issued on monthly basis or on the last Tuesday of each month till December 2013. The annual return rate was  1.44% (through half-yearly coupon) over and above the headline inflation (WPI). Through Order Matching Negotiated Dealing Systems (NDS-OM), NDS-OM (web-based), Over the Counter (OTC) market, and stock exchanges these 10-year bonds could be traded. In 2013, IIB bonds worth Rs 6500 crore.

After a certain period of time, IIB bonds lost their attractiveness, as there has been significant moderation in inflation since 2014-15. Then, later on, The IIB bonds turned highly illiquid, as WPI inflation remained negative for consecutive 15 months (as of Feb 2015) since November 2014. In order to improve the liquidity in the G Secs market, Government then decided to buy back the IIB bonds. The Government of India announced that it will repurchase the IIB of 1.44% Inflation government stocks 2023 in February 2016 through the reverse auction for an aggregate amount of Rs. 6500 crore (face value). The repurchase then was undertaken as an ad-hoc measure to redeem the government stock prematurely by utilizing the surplus cash balance.

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