[Economy] Inflation Indexed Bonds IIB, IINSS-C: Salient Features, real interest rate, nominal interest rate

In Economy by Support Staff

  1. Prologue
  2. Nominal vs Real interest rate
  3. Inflation index bonds: Salient Features
  4. IIB: How do they protect against inflation?
  5. IIB: principal also protected

Prologue

Economic Survey Chapter 4: Prices and Monetary Management. FIVE subparts

  1. Inflation indexed bonds
  2. measures of money supply: M0, M1, M2, M3, M4, Broad-narrow money
  3. Monetary policy trends, RBI restructuring
  4. Indexes’ Theory: WPI, CPI, IIP, Services index and others
  5. Indexes’ Current: Survey observations on WPI, CPI & IIP, How to combat inflation

Nominal vs Real interest rate

  • Real = nominal minus inflation.
  • Suppose SBI offering 4% on savings account (SA) and 9% on fixed deposit (FD). These are called “NOMINAL” interest rates.
  • But will they protect my savings against inflation?
  • I can find out via “real interest rate”
Nominal CPI (Inflation) Real interest rate
=Nominal MINUS inflation
SA 4.00% 11% -7%
FD 9.00% 11% -2%
  • Observe that real interest rate is “NEGATIVE number”. Meaning, inflation will ERODE my purchasing POWER, IF I invest in savings or fixed deposit.
  • Therefore, during high inflation, juntaa prefers to invest money in physical assets like gold, real estate than in financial assets like bank deposits or mutual funds.
  • Consequences: higher gold import => CAD increased => Rupee weakens => crude oil import expensive=> petrol diesel expensive => milk, veggies everything expensive due to higher transport cost.=> more inflation
  • Thus, a vicious cycle created: more inflation => more gold import.

To break this cycle, what should we do?

  • Ans. Provide an investment option where Juntaa gets POSITIVE real interest.
  • And thus, we come to our topic of discussion: inflation indexed bonds.
  • Decode the words: Bonds=> you are giving money to someone, he gives you a piece of paper, he’ll repay interest and principal.
  • But there is a caveat: this “RETURN” will be linked to inflation so if more inflation then he’ll pay you MORE.

Inflation index bonds: Salient Features

Inflation indexed Bonds IIB explained

  • 1997: Capital index Bond (CIB) had similar features.
  • Budget 2013: announced inflation indexed bonds (IIB)
  • RBI launches two type of IIB
IIB IINSS-C
Fullname Inflation indexed bonds Inflation Indexed National Savings  Securities-Cumulative
Born Jun 2013. then more launched in Aug, Sep, Nov… Dec. 2013. Stopped after March 2014.
Whocan invest? Anyone can file application BUT the allottment is made in such manner that

  • 80% of bonds allotted to institutional investors (e.g. LIC, mutual funds)
  • 20% of bonds allotted to retail investors.
ONLY retail investors can apply. Meaning

  • Individual /NRI
  • Hindu undivided family HUF
  • Charity organization
  • Educational bodies
Whosells?
  • RBI directly via auction method.
  • This money goes to Government.
  • So in a way, Government is “Borrowing” from public.
RBI “outsourced” the selling work to

  • Nationalized bank (SBI , BoB, PNB etc)
  • Axis bank
  • HDFC
  • ICICI.
Investment limit
  • Minimum 10,000
  • Maximum 25 lakhs
  • Minimum 5,000
  • Maximum 10 lakhs for individual
  • Maximum 25 lakhs for charity and educational org.
Redeem
  • You can only redeem (i.e. getting back your “principal”) after 10 years. Otherwise they’ll charge penalty
Same. But senior citizens given some relief. They can pullout money after a few years.
Trading
  • They can be traded in secondary market (via BSE, NSE etc stockexchange).
  • but if you sell your bond in secondary market and make profit, you’ll have to pay Capital gains tax. although in real life, “Buyer” will have to withhold & pay. Recall TDS concept in Vodafone.
CANNOT be traded in secondary market (BSE, NSE etc.) so once you buy, you’ve to keep it to yourself. until the maturity period (10 years).

IIB: How does it protect against inflation?

So far we learned the salient features of two types of inflation indexed bonds. BUT, HOW do they protect your investment against inflation?

Return (interest rate) on these bonds

IIB IINSS-C
  • 1.44% + WPI (Base year 2004)
  • Four month lag
  • Compounded half yearly
  • 1.5% + CPI (Combined) base year 2010
  • 3 months lag
  • Compounded half yearly

Explanation, Suppose

  • 1st Jan 2014: You’ve invested Rs.10,000 on IINSS-C.
  • On June 2014, Rajan will count the interest rate to be paid to you. Using CPI data of four month earlier i.e. Feb.2014
  • In Feb 2014, CPI was 8.03
  • Therefore you’ll earn 1.5+8.03=9.53% interest

So, is your “investment” protected against inflation? Well we can simply cross check by finding “REAL INTEREST RATE”.

nominal MINUS Inflation =REAL interest rate
9.53% -8.03% +1.5%
  • This time, real interest rate is a POSITIVE number. So, yes, Inflation indexed bonds protect your savings against inflation.

IIB: principal also protected

  • In the above example, you’ve invested Rs.10000 in IINSS-C.
  • You redeem after ten years, IF CPI inflation is 60% that time, you’ll get 16,000 rupees. (This is only for illustration, real calculation has more caveats.)
  • 1997: RBI had launched CIB (Capital indexed bonds). They only protected the interest from inflation but did not protect principal from inflation.
  • But both of these new bonds protect your (principal + interest) from inflation.