Inflation Indexed Bonds

What are Inflation Indexed Bonds?

Inflation is bad for investments. How is that? High inflation eats into your profits, reducing your actual return. The inflation in November 2022 was close to 7%, indicating that if you made 10% on your investments post-inflation, your returns are just 3%. While high-yielding investments can help mitigate inflation, certain investments, such as inflation-indexed bonds, also inflation-proof a portfolio. 

These bonds help protect investors’ wealth from the negative impacts of inflation. Also, these bonds pay a fixed rate of interest and return the principal to the investor at the time of maturity, just like any other bond. But they pay the interest on the inflation-adjusted principal.

How Do Inflation Indexed Bonds Work?

These bonds are linked to the consumer price index (CPI), an index that measures inflation. Also, the index rises and falls as inflation changes each month. Since the bonds are linked to inflation, the bond’s principal amount is also adjusted according to inflation.
When inflation rises, the principal amount also increases, and you will earn interest on this new principal amount. If the inflation falls, the principal amount also falls, and you will earn interest on this new amount. 
At the time of maturity, the bond will pay the original investment amount, or adjusted principal amount, whichever is lesser. However, if the adjusted-principal amount goes below the invested amount, then the investor will get the investment amount back. Hence these bonds not only inflation-proof a portfolio but also offer capital protection. 

Let’s take, for example, the inflation is 2%, and you decide to invest Rs 1,00,000 in these bonds for two years at a coupon rate of 4%. You will earn interest on Rs 1 lakh for a normal bond, but for this bond, you will earn interest on Rs 1,02,000 as it is adjusted for inflation. 
In the next year, the principal at the start of the year is Rs 1,02,000, and if the inflation is -2%, then the new principal amount is Rs 99,960, on which you will earn an interest of 4%. But you will get back Rs 1,00,000 on maturity, as these bonds offer capital protection. 

How is Interest on an Inflation Indexed Bond Calculated?

The interest is calculated on the adjusted principal amount for these bonds. Also, the principal is adjusted for inflation each year. Let’s understand it with the help of an example.
Let’s say Mr Anil Kumar invested Rs 1 lakh in inflation indexed bonds for five years for a coupon rate of 4%. The following table shows the interest calculation for five years.

Year	Principal (Rs)	Inflation	Inflation-Adjusted Principal (Rs)	Interest (4%) (Rs)	Total Return (Rs)
Year 1	100,000	5%	105,000	4,200	9,200
Year 2	105,000	4%	109,200	4,368	8,568
Year 3	109,200	6%	115,752	4,630	11,182
Year 4	115,752	5%	121,540	4,862	10,649
Year 5	121,540	3%	125,186	5,007	8,654

For a normal bond, interest for the first year is calculated at Rs 1,00,000, but since this is in an inflated indexed bond, the interest is calculated at Rs 1,05,000. For next year, the interest will be calculated at Rs 109,200 as this is the inflation adjusted principal. Also, each year, the principal increases as inflation is high. Furthermore, if inflation is below zero (deflation), the principal amount reduces, and interest will be calculated on this reduced principal.

History of Inflation Indexed Bonds

These bonds were first issued as Capital indexed bonds (CIB) in 1997. Also, these bonds offered protection against inflation to the principal, not the coupon rate, and were issued at a 6% interest. However, in 2013, the government issued inflation indexed bonds in the name of CIB and offered protection against inflation for both principal and interest amounts. 

These bonds were first linked to the wholesale price index (WPI) and paid a coupon of 1.44% per annum on the adjusted principal at the end of the term. Also, these bonds had a maturity of 10 years, and the investor’s money was locked in for the entire time. Moreover, the WPI was below zero for almost 15 months, making these illiquid. Investors were also not willing to invest in them after the Reserve Bank of India (RBI) changed its inflation measure to CPI from WPI. 
However, the government bought back these bonds, and if it issues them in the future, it will be based on CPI.

Advantages and Disadvantages of Inflation Indexed Bonds

Advantages

• No inflation risk: These bonds have no inflation risk. Also, they protect the investment against inflation by adjusting for inflation. 
• Fixed returns: These bonds offer fixed returns, which most investors prefer. They are stable investment options during volatile periods.
• Good long-term investments: The maturity of these bonds is around ten years, and hence they qualify for long-term investing. Since they give fixed returns for the long term, they are good investments. 

Disadvantages

• Lower potential than other investments: These bonds have low potential than other investments like shares or mutual funds. They cannot give very high returns during a bullish market phase. 
• Not a perfect measure of inflation: CPI is an inflation metric, and these bonds are linked to it. But CPI has many flaws and isn’t a perfect inflation metric. Hence it is difficult to say whether these bonds are actually giving inflation-beating returns. 
• Tax on phantom income: The bond’s principal amount is adjusted for inflation but the investor only receives at the end of the maturity period. The inflation-adjusted amount is often treated as gains for the purpose of taxation. Hence investors will be paying tax on this phantom income, that is, income that they earn but have not yet received.

Risks of Inflation Indexed Bonds

• Interest rate risk: Interest rate fluctuations can affect these bonds’ value. Also, an increase in the market interest rates can lead to a fall in the value of these bonds.
• No protection against deflation: These bonds do not offer any protection to the investor during deflation. The bonds’ principal will come down during periods of inflation, and so will the interest rates.  

Taxation of Inflation Indexed Bonds

The tax treatment for these bonds is like any other debt instrument. Also, the capital gains are subject to a long-term capital gains tax of 20% with an indexation benefit. Furthermore, the interest is taxable at the investor’s income tax slab rate.

Frequently Asked Questions

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