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What is an Inflation Indexed Bond?

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Synopsis:

Inflation indexed bonds are issued by the Reserve Bank of India (RBI) and provide investors protection against inflation. This is how they work. The government increases their principal every year based on the consumer price index (CPI). A flat coupon rate is applied to the adjusted principal every year. Hence, the investors get a fixed coupon rate over and above the rate of inflation. While such bonds protect against inflation, they usually offer lower yields than other bonds. Hence, they may not be the best investment option for everyone.

Inflation Indexed Bonds

When you live in a developing nation like India, you might have to face the harsh reality of high inflation, which reduces the value of money every year. What costs you Rs. 100 today will mostly cost you more than Rs. 100 a year from now.

Most investment options do not offer you protection against inflation. However, inflation indexed bonds offer you guaranteed protection against inflation. Besides, they are issued by the Reserve Bank of India (RBI); hence, they have high creditworthiness. Read this blog, as it explains what an inflation indexed bond is, the benefits and risks of investing in such bonds, and many other aspects related to them.

What is an Inflation Indexed Bond?

Inflation indexed bonds are meant to protect investors against the risk posed by inflation. They are issued by the RBI. When you invest in a regular bond, you typically earn a fixed interest on it.

Suppose you invest in a bond with Rs. 100 face value and a 10% coupon rate. Your nominal interest earning is 10% in this case; however, this doesn’t consider inflation. Suppose inflation is at 4%, your return net of inflation is 6%. But, if inflation reaches 8%, your return net of inflation is just 2%.

Hence, regular bonds expose investors to inflation risk. To deal with it, they can invest in inflation indexed bonds, which provide them with a shield against inflation so that their net return is not adversely impacted by inflation. Now that you have understood what an inflation indexed bond is, let’s delve deeper into this topic.

How Inflation Indexed Bonds Work

Inflation indexed bonds change the principal and interest payments in such a manner that the impact of inflation is negated. For inflation, the consumer price index (CPI) is considered. Let’s understand this with an example.

Let’s say that you have invested in inflation indexed bonds with Rs. 1,000 face value and a 2% coupon rate. Suppose the inflation in the first year is 3%. In this case, you will earn a 2% interest on the face value increased by 3% or on Rs. 1,030 (1,000 X 1.03). So, you will earn Rs. 20.6 interest. However, suppose the inflation drops to 2% in the second year. Then, you will receive Rs. 21 as interest in the second year (1030*1.02*2%).

Essentially speaking, you are getting a 2% interest rate over and above inflation in this case. Hence, your real yield (after deducting inflation) remains at a constant 2%. This is how inflation indexed bonds protect investors against inflation.

Benefits of Investing in Inflation Indexed Bonds

The main benefits of such bonds are explained below:

  1. Protects the real value of your investment: As inflation indexed bonds protect you against inflation, the real value of your investment remains intact. No matter what the inflation rate is, with these bonds, you are assured that you will get interest over and above that inflation; hence, your returns are protected.

  2. Safety of investment: These bonds are issued by the RBI. Hence, they come with backing from the central government. Therefore, you are assured that you will certainly get your money back. Compared to this, bonds issued by private companies or other corporations may or may not have a high credit rating.

Comparing Inflation Indexed Bonds with Traditional Bonds

Traditional bonds do not protect you against inflation. As inflation moves up and down, your returns can be significantly affected in the case of traditional bonds. Let’s understand this with an example.

Suppose you invest in a traditional bond with Rs. 1,000 face value and a 7% coupon rate. Therefore, you are entitled to receive Rs. 7 per year interest income. Let’s say the inflation is 4% in the first year. Your net interest income (7% - 4%) is 3% of Rs. 1,000, which is Rs. 30.

However, let’s say the inflation increases to 6% in the second year. Now, your net interest income is Rs. 10 [(7% - 6%) X 1,000]. In the case of a traditional bond, your interest income net of inflation will vary based on inflation.

Compared to this, inflation indexed bonds offer you complete protection against inflation, as illustrated earlier in this blog.

How to Invest in Inflation Indexed Bonds

In India, people can invest in inflation indexed bonds through government websites, banks, and the websites of brokers. Through these channels, you can invest in “Inflation Indexed National Saving Securities – Cumulative (IINSS-C).” These securities are issued by the government. 

The government changes the principal of these securities based on CPI to protect investors against inflation. On maturity, if the value of your principal is higher than the amount initially invested, you will receive the higher amount. However, if upon maturity, the value of your principal is equal to or lower than the original amount invested, you’ll get the original amount.

Potential Risks and Considerations

If you want to invest in inflation indexed bonds, you should be aware of the following risks and considerations:

  1. Low returns: Inflation-indexed bonds typically offer lower yields than regular bonds. If they were offering a higher yield than regular bonds, no one would invest in regular bonds. Besides, inflation indexed bonds offer much lower returns than equity over a long period.

  2. Fluctuation in prices: As interest rates move up and down in an economy, the price of inflation indexed bonds can change, too. Hence, if you are thinking of selling them in the secondary market, you are taking market risk by investing in them because you may not get the price you desire when you want to sell them.

  3. CPI may not be the best measure of inflation: Some experts warn that CPI is not the best measure of inflation in India. However, inflation indexed bonds consider CPI data to estimate inflation. Besides, the actual inflation rate may vary from person to person. Hence, even though such bonds try to protect you against inflation, depending upon how the prices of goods you consume change, these bonds may not provide adequate protection to you.

Conclusion

Having learnt what an inflation indexed bond is, you’d agree that they are an interesting instrument. However, like any other investment class, they have their merits and demerits. Therefore, before you invest in them, you should understand them thoroughly and you should analyse whether they suit your investment objective.

For example, if you are young (less than 40 years of age), you want to invest for the long-term, and you have a high risk-bearing capacity, then equities may offer a much better return adjusted for inflation than inflation indexed bonds. In the end, your investment objective and your risk-taking capacity should help you decide whether you should invest in these bonds.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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Frequently Asked Questions

What is an inflation indexed bond?

Answer Field

These bonds protect your returns against inflation. As a result, your yield in percentage terms remains flat over your investment horizon.

How do inflation indexed bonds work?

Answer Field

The government increases the principal of these bonds every year based on inflation. On the principal thus adjusted, the interest is calculated by applying the coupon rate. By doing this, the government protects the interest and principal of investors against inflation.

What are the benefits of investing in inflation indexed bonds?

Answer Field

These bonds protect the real return on investments by providing a shield against inflation. Besides, they are issued by the government; hence, their creditworthiness tends to be very high.

How are inflation indexed bonds different from regular bonds?

Answer Field

Regular bonds don’t offer protection against inflation; however, inflation indexed bonds are designed to provide such protection.

Who should consider investing in inflation indexed bonds?

Answer Field

Those investors who want guaranteed protection against inflation should consider investing in these bonds.

What are the risks associated with inflation indexed bonds?

Answer Field

Their prices change based on the level of interest rates. So, you take market risk by investing in these bonds. Besides, the CPI may not be the best benchmark for inflation. Hence, such bonds may not offer you adequate protection against inflation.

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