The purpose of inflation-indexed bonds is to offer a fixed annual return even when there is high inflation. The principal amount or the initial investment is adjusted against inflation every year. This amount earns a fixed interest rate. x
However, it is pertinent to note that interest is not paid out annually but is compounded with the principal on a half-yearly basis. The total interest accrued is paid with the principal amount at the time of redemption.
Let us look at an example for illustrative purposes:
| Principal Amount: Rs 10,000
Rate of inflation: 3%
Coupon rate: 3%
Inflation accrual: Rs 300
Principal adjusted against inflation: Rs 10,300 (including 3% inflation)
Interest: Rs 309 (at 3%)
Total Return: Rs 609
So at the end of the first year, Rs 609 was the total return on the Rs 10,000 investment made. This amount keeps increasing as the inflation rate goes up. In India, inflation calculation for such bonds is done on a half-yearly basis. |
The sovereign authority of each country issues inflation-indexed bonds. In India, the Reserve Bank of India (RBI) is the issuing authority. The average duration of the bond can range from five years to up to 30 years.
In 1780, in the US, Massachusetts issued the first inflation-indexed bond. This was in fact offered to soldiers as compensation to reduce the impact of the price rise and the inability of the common man to afford basic items. And slowly but steadily, these bonds started to get popular worldwide. The UK issued these bonds in 1981.
India entered the fray in 1997 through something called capital-indexed bonds.
These capital-indexed bonds originally only offered inflation protection to the principal amount. But in 2013, these were renamed inflation-indexed bonds where there was protection against inflation for the principal amount and interest payments.
Taking these bonds as the reference index, mutual fund houses also launched inflation-indexed bond funds. However, these were discontinued by 2015 as the pace of inflation fell.
There have been multiple changes in the inflation-indexed bond market since then.
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When inflation-indexed bonds and related funds were issued in 2013, inflation was on the rise. But since their issuance inflation moderated, leading to a halt in the MF schemes linked to these bonds.
Initially, the wholesale price index or price changes in the wholesale market were used as the index for these bonds. In 2014, RBI adopted the consumer price index or retail market price changes as the benchmark for inflation bonds. So whenever new inflation-indexed bonds are issued and allied mutual fund schemes are launched, they will be linked to the retail inflation rate.
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Liquidity or the ability to withdraw funds for emergencies could be crucial across any investments that you make. Inflation-indexed schemes are no different. A short-tenure scheme could enable better liquidity. For example, if the bond duration is 20 years, this means that your money is locked in for that period. While premature withdrawals are typically allowed in inflation-indexed bonds, there could be penalties imposed.
In addition, monitoring the fund performance annually could be a good indicator of the returns generated by the investment. However, these returns may not be comparable with the other equities or debt products.
Like other investments, there could be downside risks too. If inflation falls rapidly, the value of inflation-indexed schemes could reduce as well. However, that situation aside, such products linked to a country’s inflation could be a good hedge against consistent price rise.
This article is for information and educational purposes only. It is meant only for use as a reference tool. It has not been prepared for any particular person or class of persons. The products and services mentioned here may not be suitable for everyone and should not be used as a basis for making investment decisions. This article does not constitute investment advice nor is it an offer, solicitation or invitation to transact in any investment or insurance product. The value of investments and the income from them can go down as well as up, and you may not recover the amount of your original investment. Prior to transacting, you should obtain independent financial advice. In the event that you choose not to seek independent professional advice, you should consider whether the product is suitable for you. You should refer to the relevant offering documents for detailed information.
Standard Chartered Bank is a distributor of mutual funds and referrer of other third party investment products and does not provide any investment advisory services as defined under the SEBI (Investment Advisers) Regulations, 2013 or otherwise. Investments are subject to market risk. Read scheme related documents carefully prior to investing. Past performance is not indicative of future returns.
