Should you invest in inflation-indexed bonds?


The first tranche of inflation-indexed bonds are scheduled for June 4, 2013. Do read on to understand whether the bonds will really benefit you.

Investors are often told to diversify their portfolio across various asset classes like gold, equity, bonds, among others. Though most people are familiar with these financial products, we will just recap the same for those with no financial background.

Stocks offer an ownership stake in the company, while bonds are similar to loans made to a company. On maturity of the bond, the investor is refunded the original principal. The interest component is paid annually, unless otherwise specified.

Without digressing, let’s understand the rationale for these bonds which were announced in the Budget 2013 by Finance Minister P Chidambaram.

What is an inflation-indexed bond?

Inflation-linked bonds aim to provide security of capital and protection against inflation. It was introduced by the Reserve Bank with the motive to wean away investors from physical gold.

Till recently, interest earned on bank deposits were negative keeping in the mind the high inflation rate.

Now, with returns on these bonds linked to the wholesale price index, investors can be assured that the returns will beat inflation.

How do these bonds operate?

The principal amount is linked to the inflation rate so that the impact is muted. Any increase or decrease in the inflation rate automatically results in an adjustment in the principal.

Tenure

The bonds come with a 10-year tenure and fixed coupon or interest rate.

Payment of interest:

Interest is payable every six months. To compute the interest rate, current inflation in the economy will be adjusted by an ‘inflation indexation factor’ for every interest payment period.

Periodic coupon payments are paid on the adjusted principal.

To simplify, let’s assume a bond with a principal value Rs. 100 carrying a coupon rate of 8%. If inflation is 10%, then the bondholder is paid an interest on the adjusted principal of Rs. 110, i.e. Rs. 8.80. Similarly, future interest payments will be based on the adjusted principal.

In this way, the bonds provide inflation protection as well capital security. On maturity, the adjusted principal or face value, whichever is higher, will be paid.

Tax benefits

The bonds will not receive any special tax benefits and existing income tax rates will be applicable beyond the prescribed limit.

Is there an option to exit before the term ends?

The instrument will be traded like any other government security, thus giving investors a chance to exit their investments.

Will it be really beneficial?

Since the rate of return is based on wholesale inflation and not as per the higher consumer price inflation, investors will receive negative returns on their investment.

What you need to check?

Before investing, kindly note the initial coupon rate on the bond. A coupon close to the prevalent bank fixed deposit rate would be the best bet.

Read more:

Difference between stocks and bonds

Should you invest in tax free bonds?



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