Friday, 11 March 2011

Inflation-indexed bonds are to be promoted

The major problem of almost all investments is inflation related issues. If you get a fixed percentage of interest or income and when we compare it with the rate of inflation it is nothing. Some investment experts may say that investment in gold help you a lot to go with inflation. Yes up to a certain extent it is correct, but when we compare the price of gold and the rate of inflation it won’t we be much profitable. Just like all other investments. In PPF we get 8% interest and the rate of inflation is around 6% to 8% from various surveys. If we consider the least 6% inflation rate we get only 2% increase from PPF. The interest from PPF is exempted from tax as per the present tax rules. If we invest in any other investment scheme which has no tax exemption, we got nothing out of the investment. The only thing is that we can keep the investment amount par with inflation.

In such a condition the inflation indexed bonds help a lot. Inflation indexed bonds or inflation linked bonds which are designed to cut out the inflation risk of an investment by indexed the principal amount to inflation. The economic times reported about the matter and they say that the government must take effort to push the bond. Let us see the report as it is.

Inflation-indexed bonds need concerted push from government

Today's inflationary environment may require major adjustments in priorities of investments. Inflation is increasingly becoming a threat to the government, companies and individuals. Higher inflation could drag growth prospects of the country by escalating the cost of funding. Similarly, companies are hit by rising input costs. Skyrocketing prices are hurting household budgets and those who live on interest income are experiencing worse erosion in their purchasing power.

Higher life expectancy in the country requires additional post-retirement planning, especially for those who are young, by not just building more nest eggs but getting inflation-hedged returns in the long run.

In this context, the RBI's move to introduce inflation-protected bonds will provide some relief. The central bank published a technical paper on inflation-indexed bonds (IIB) in December 2010 to gather comments and suggestions.

Unlike nominal or regular bonds that may give negative real returns in an inflationary environment, IIBs insulate one's investments against inflation. These bonds keep intact the purchasing power of an investor's savings by adjusting both interest and principal according to the price index.

So, if prices go up, so too does the bond payout. As the adjustment of coupon continues for the entire tenure of the bond, IIBs are considered riskless long-term investment worldwide.

More than 30 countries issue IIBs. The first IIB issued by the Massachusetts Bay Co back in 1780 was linked to the cost of silver. The practice gathered pace only after the UK issued Inflation-Indexed Gilts in 1981. Soon, others such as Australia (1985), Canada (1991), Poland (1992), Sweden (1994), New Zealand (1995), France (1998), Greece (2003) and Italy (2003) followed.

The next big push in the IIB market came when the US treasury issued Treasury Inflation-Protected Securities (TIPS) in 1997. Although the RBI also issued these bonds in the same year with a five-year tenor - technically called 6% Capital Indexed Bond, 2002 - there were no further issuances for want of enthusiastic response. In contrast, according to an estimate by Barclays and Credit Suisse, the US treasury will auction $120-125 billion TIPS in 2011, after boosting issuance by 48% to $86 billion in 2010.

So why are these instrument a success globally? Protection from future inflation risk and its effect on the purchasing power on one's investments are the key forces behind the growth of inflation-indexed markets.

Issuance of IIBs is a win-win for both the investor and the issuer.

Regular issuances of IIBs by the government would help provide the inflation hedge to the investor in the long run. Also, for the investor, these bonds have a relatively lower correlation with other standard asset classes making them ideal for portfolio diversification.

Adding IIBs to the spectrum of debt instruments allows government to save on notional inflation risk premium paid out on nominal bonds. IIBs, however, remove the investor's inflation risk. So, by issuing indexed bonds, the government can avoid paying inflation risk premium and bring down its borrowing costs.

Products such as pension plans, provident fund and public provident fund available in the country offer assured nominal returns. Most retail investors, however, do no understand the difference between nominal and real returns. Investor awareness about the benefits of real returns over nominal returns would go a long way in creating a market for IIBs, as investors would then shift from assured-return products whose real returns in inflationary times are neutral, if not negative.

The IIBs need to be issued for different tenures. The US TIPS are issued for different maturities and denominations. This will enable a vast set of investors - retail investors, mutual funds, pension funds and insurance companies - with different time horizons to take benefit of this instrument.

In turn, mutual funds, pension funds and insurance companies can offer IIB-derived products to their clients in the form of inflation-hedged funds, annuities and insurance plans. In fact, developed countries have constructed products such as inflation-linked swaps, options and swaptions in the derivatives space with the underlying asset as IIBs, and emerging-market inflation-linked funds that take advantage of rising inflation and strong economic growth potential of emerging economies.

Since their introduction in the UK, pension funds and insurance firms have been increasingly drawn to indexed bonds, holding nearly 80% of indexed bonds. In the US, mutual funds and investment trust hold 10% of these bonds.

To create a market for inflation-indexed bonds in India, the government needs to encourage pension funds and insurance companies to invest in these bonds. These bonds should be income-tax exempt, else the real post-tax return may turn out to be negative. Also, government will have to create liquidity of the bond by offering buyback option and creating investor protection cell to handle the grievances of buyers of IIB-derived products. Currently, government employees have protection in the form of dearness allowance. Introducing IIBs would be the first crucial step towards widening the net for inflation-protection cover for the masses.

Original Post

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