The principal and interest payments of the inflation-indexed bonds are usually linked to an inflation index such as WPI or CPI.
The government on Monday made a few announcement which cheered the struggling Indian sovereign bond market. Department of Economic Affairs (DEA) Secretary Subhash Chandra Garg announced that the government borrowing in the first half of the fiscal will be limited to Rs 2.88 lakh crore or nearly 48 percent, much lower than 60 percent to 65 percent in last years. Following the announcement, the yield on the benchmark 10-year bonds declined 25 basis points to 7.37 percent, and is set for its biggest plunge since November 2013. The other important announcement was with respect to inflation-indexed bonds (IIBs). The IIBs linked to consumer price index (CPI) will be issued in the next fiscal, Subhash Chandra Garg said.
IIBs are very popular all across the world since they are designed to protect investors from inflationary forces which eat away their savings. In a country like India where a bulk of people lock their savings in idle asset such as gold, IIBs are very attractive financial instruments. The principal and interest payments of these bonds are usually linked to an inflation index such as WPI or CPI. It was in the year 1997 that inflation-linked bonds in the name of Capital Indexed Bonds (CIBs) were first issued. These provided protection only to principal and not to interest payment. In 2013, new bonds by the name of inflation-indexed bonds (IIBs) were issued which provided protection to both principal and interest payments. These IIBs were linked to the WPI. This time IIBs are linked to CPI.
Reason for issuance of IIBs in 2013
The Indian economy in the year 2013 was struggling with a twin deficit problem of widening fiscal deficit and expanding current account deficit (marked by huge gold imports). Raghuram Rajan, the then RBI Governor, launched these bonds later in the year. The RBI also issued Inflation-Indexed National Savings Certificates linked to CPI for retail investors. The bonds then offered a coupon rate of 1.5 percent per year over the existing inflation rate.
How do they work?
The principal is multiplied with the index ratio in order to adjust the inflation component on principal in principal. The face value or the adjusted principal – whichever is higher – is paid to the investor at the time of IIB redemption. Interest payments are received by the investors at regular intervals of time.