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Inflation Indexed Bonds

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Investors usually invest in various thematic bonds to earn decent interest on their capital investment, but in such thematic bonds, there is always a risk of loss due to various factors. For example, if an investor invests in a stock exchange and the inflation rate rises then the stock market tends to fall and the investor may bear huge losses. Inflation is one such factor that severely affects almost all kinds of investments, except the Inflation Indexed Bonds. Inflation Index Bonds (IIB) are specially designed to provide security to an investor against inflation.

What is an Inflation Indexed Bond?

An Inflation-Indexed Bond is a Bond i.e. indexed with inflation and its rate of interest goes up and down with the level of inflation in the country. This bond is specially designed to safeguard an investor’s investment from future uncertainties about the inflation rate. The idea of Inflation Indexed Bonds was first coined by Massachusetts Bay Company in 1780, and in India, it was first introduced by RBI in 1997 as Capital Indexed Bonds (CIB). However, there is a slight difference is in the older CIB, and the newly introduced IIB, as CIBs tend to provide inflation protection to interest only. While IIBs provide inflation protection to both interest and principal amounts. 

How does an Inflation Indexed Bond work in India?

When investors invest a certain amount in the IIBs he attracts a fixed interest on that amount, which can be withdrawn each year. However, this investment also attracts an inflation component which means the rate of interest received due to inflation. But the amount that comes out due to the inflation component is not added to the regular interest and is paid on annual basis. The Inflation component is multiplied by the principal amount and is paid at the time of maturity of the bond and paid along with the principal amount. 

The yearly interest on the principal amount is paid to the investor by a fixed coupon rate, while the principal amount is paid at the time of bond maturity. IIBs have a fixed value (FV) and if the adjusted principal (Principal amount X Inflation Component) is below FV due to deflation then FV is paid to the investor at the time of redemption. If the adjusted principal is higher than the FV then the adjusted principal amount is paid to an investor. In this way, RBI protects the investment of an investor with varying rates of inflation.

Inflation-Indexed Bond with Varying Rates of Inflation

Inflation-Indexed Bond with Varying Rates of Inflation

As per the RBI’s press release the issuance size of IIBs for each tranche will be between INR 1000-2000 Crore

How to Calculate Index Ratio?

To calculate the index ratio, you must be aware of the WPI (Wholesale Price Index) as it’s being considered in the calculation of the Index ratio WPI is considered no CPI (Consumer Price Index). As the CPI reflects inflation on a large scale and thus RBI decided to use WPI for the calculation of the index ratio. The Wholesale Price Index or WPI is an index that showcases the rise or fall in the price of wholesale products in the basket. Additionally, the CPI releases in January 2011 and needs some more to time stabilize. 

So, the index ratio can be easily calculated by dividing the reference WPI on the settlement date with the reference WPI on the issue date.

Calculation of Index Ratio

Calculation of Index Ratio

Advantages of Inflation Indexed Bonds?

There are many advantages of investing in Inflation Indexed Bonds and some of them are listed below.

  • The principal amount is protected in the Inflation Indexed bonds which means, an investor will at least get back his whole principal amount.
  • The Inflation Indexed Bonds provide extra interest according to the rate of inflation.
  • in IIBs an investor not only gets an additional rate of interest due to inflation but also gets a fixed rate on the principal amount and can withdraw annually.
  • The Inflation Indexed Bonds not only provide security to your interest but also the principal amount.
  • The IIBs are usually backed by the central government, thus there lesser chances of discrepancy.

Last Updated : 01 Sep, 2022
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