Bond against Inflation

With an ever increasing import of gold and nose-diving Rupee, government is forced to reckon with the idea of providing a hedge  to investors against  the return eating monster i.e. inflation.  Gold has become  only solace for investors to park their surplus as every other financial instrument has surrendered before the might of stubborn double digit Inflation. Reserve bank of India is now seriously considering to open the window of Inflation Index bonds- a  debt instrument  offering protection against high inflation.

India’s fresh lure of gold is predominantly driven by financial investment needs. Gold imports in India have risen to its peak and resulted in a panicky level of current account deficit and weak rupee resultantly. Apart form making gold imports costlier govt wants to divert the gold buying frenzy towards a befitting investment alternative. Inflation Indexed bond comes as an appropriate option in this context.

Inflation indexed bonds are those overall return on which is adjusted against increasing inflation. Inflation indexed bonds are popular and successful in USA, UK, Australia, Sweden and many other developed countries.  India introduced a derivative of the same i.e. capital indexed bonds earlier in 1997, then again in 2004 but the bond failed to garner attention as only principal amount was indexed against inflation not the coupon rate, consequently the real returns remained unprotected from inflation. RBI is again considering for a new avatar of IIB amid a couple of ifs and buts.

A robust inflation index is the most important pre-requisite for IIBs. India has several inflation measuring indices, ranging from wholesale to retail Inflation. It is still not clear which one would be used for pegging return on IIB . That IIB may disrupt the G-sec market is also a prevailing concern for the central bank. Government securities are the major source of govt  borrowings.  Fixed interest of G-sec will surely make the former i.e. IIBs a preferable investment option over the latter.

The timing of issuing IIBs is also a point to ponder.  Govt or issuer has to shell out  more money during the high inflation period. Considerate thought must also be given to defining tax rate on IIBs returns. Higher taxation on the same will eat into the vitals of returns.  It would be ideally prudent that IIBs are left tax-exempted otherwise it will be of no significance to investors.

IIBs are a welcome concept but the current challenge is to tame the lure of gold to contain higher gold imports. Given the policy bottlenecks of IIBs, it seems doubtful if it can provide equivalent benefit as gold does. Returns on gold is already three times higher than inflation rate with the prospect of spurring further. Gold-indexed bonds , yielding similar returns as this metal does in physical form, could become a better idea in the short run. A cornucopia of IIB and GIB  may do a lot better in the given situation of Indian economy.