Inflation Index Bonds: Five things you must know

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Inflation Index Bonds: Five things you must know
 
Inflation indexed bond is not a plain vanilla financial instrument. The real working of these bonds will be out only post 4 June 2013.  Investors need to understand these bonds thoroughly before taking a call of investments

No financial instrument has made the news in India in recent times like Inflation Indexed Bonds (IIBs). There is a lot of curiosity and excitement about these bonds. For some it looks like a panacea for all woes related to inflation, while for others it is still a Pandora’s Box. While the complete picture of these bonds will be out after the first issuance of these bonds, here are five important things that retail investors must know about these bonds before investing in these bonds:

A retail investor cannot quote the price/yield of his choice during issuance: Inflation index bonds will be issued through a process of auction. Retail investors will be able to buy Inflation Indexed Bond (IIB) through a process of non-competitive bidding. Non-competitive bidding means that a person would be able to participate in the auctions of dated government securities without having to quote the yield or price in the bid. As per the RBI (Reserve Bank of India) website in a non-competitive bidding, “Eligible investors cannot participate directly. They have to necessarily come through a bank or a primary dealer (PD) for auction. Each bank or PD will, on the basis of firm orders, submit a single bid for the aggregate amount of non-competitive bids on the day of the auction.”So retail investors become price takers in inflation index bond issuance process.
Face value of inflation indexed bond will be adjusted to inflation: In the inflation index bond face value of the issued security will be adjusted to the cash flow. The coupon will be paid on the adjusted face value; however the coupon decided at the time of issuance remains same till maturity. Effectively the coupon payment received by the investor changes but the coupon fixed at the time of issuance is not altered. Let us look at the example below of an inflation indexed bond at the time of issue:
·         • Face Value: 100
·         • Maturity: 10 years
·         • Coupon: 6% per annum, payable semi-annually
Now assume the inflation changes by the inflation number given below in the period one. As a result of the change in inflation a new face value is arrived at which is 103 and coupon payment of 3% is made on the inflation adjusted face value which translates into 3.09%. In the 5th year, inspite of negative inflation of 8%, the face value does not fall below 100. As per the RBI circular the face value of inflation index bond will never go below par value.
Period
Principal
Inflation, Semiannual
CashFlow
0
100
1
103
3%
3.09
2
107.12
4%
3.21
3
109.798
2.50%
3.29
4
107.602
-2%
3.23
5
100
-8.00%
3.00
6
104.5
4.50%
3.14
7
109.725
5%
3.29
8
115.8696
5.6%
3.48
9
122.8218
6%
3.68
10
126.5064
3%
130.30
Note: This is only an example for understanding the working of IIB and not actual
working.

Real yield of inflation index bond may become negative:  Real yield here means that the inflation exceeds the yield offered by inflation index bonds. This has happened in both UK and US markets.  In order to buy inflation indexed bonds, the investors quote a very high price which results into a very low yield for these bonds. If the inflation exceeds quoted yield, real return becomes negative. In March 2013, the UK Treasury 2.5% 2024 index-linked bond had a current real yield to maturity (the return you get, after inflation, if you buy now and hold until the bond is paid back in 2024) of minus 1.06%. The US Treasury 0.625% 2021 bond had a real yield of minus 1%. The primary market issuance of these bonds in the US were also done at negative yield.