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

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  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.

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36 Comments on “[Economy] Inflation Indexed Bonds IIB, IINSS-C: Salient Features, real interest rate, nominal interest rate”

  1. i appreciate your efforts Mrunal. I hope you truely know how helpful you have been to the students fraternity who is preparing for exams.

    God Speed

  2. sir i’m confusd abt CGT if upsc asks who will pay CGT BUYER OR SELLER THN WHICH ans should i mark?

    1. in CGT case only buyers have to pay…acronym vl be….CGTB

      1. @Amit
        I am a bit confused.
        last year a friend of mine had to sell his house.
        he sold for 50 lacs but the buyer didn’t had to pay CGT ; he himself had to pay tax and to not pay tax he invested in capital gain tax bonds of NHAI…
        so in this case seller had to pay the tax….

        1. Seller has to pay tax in case of capital gain there is no doubt about it. This year govt has introduced one amendment to income Tax act now buyer has to deduct tax(tds) @1% if purchase consideration is more than fifty lac, that too from this purchase consideration ie seller’s money and pay to the govt

  3. Very nice article. Many of my long pending confusions got cleared. Just one suggestion (request), please replace the word “principle” with “principal” used at many places in this article (also in some of your other articles). It creates confusion. Although I know many people in Rajsthan pronounce principal as principle, in needs to be clarified for people from other parts of India.

    Thank You!

  4. What the difference between protecting principle from inflation and interest from inflation? Please explain.

    1. krishna suppose you loan me Rs.1000 at 10% interest rate
      then Rs.1000 part is principal and Rs.100 part will be interest
      IIB bonds protect both of them from inflation. so if more inflation then you’ll receive more money from both parts.

  5. Mrunal Sir!!

    will the investor get tax rebate while investing in IINSS-c?

  6. VRY VRY THANKS

  7. Thank you sir:):)

  8. English comprehension exclusion notice now on upsc site also : http://www.upsc.gov.in … just for info .. same thing already mentioned in DoPT notice … best of luck to all

  9. Is it mandatory for institutional investor (eg LIC) to purchase the IIB?
    Sometime these guys weep in the corner that we have to clean the mess/bad deeds of govt instead of spreading the market, after all by spreading the market means employment generation. Also by taking money out from this insti how the liquidity of market will go down and finally inflation ease out. (just a confusion)

  10. @Mrunal

    CAN YOU PLEASE WRITE AN ARTICLE ON AFSPA. plz like me many others are awaiting to read an article on AFSPA from you.
    Loves the way you explain..

  11. The best website… Loves the way you explain…..may the Allah bless you for such a great efforts.

  12. Mrunal ji tusi great ho……tohfa kabool karo…..:)

  13. @Mrunal

    If I may add to the Article:

    Incase Inflation is less than The interest rates provided by the banks, in such case IIB may incur loses !?

    e,g :

    If Inflation(CPI/WPI) is 4% and the Bank Deposit rates are 9%, then applying the above formulas

    IIB gives us 4% + 1.44 or1.5 = 5.5% v/s 9% interest provided by the banks ???

    Kindly comment. This is perplexing

    1. Dr. Zaid

      Just to add, If inflation is less then the interest rates of banks will automatically come down. RBI will reduce the rates as inflation eases.

    2. Of course yes, as we know urjit patel has given enthralling recommendations whereby RBI intends to bring CPI down to 4(+-)2 % range (target 6% in 24 months), these bonds are expected to earn us less after probably a couple of years (for 7-8 years as maturity = 10yr). Interest range might lie somewhere between 6-8% ( I don’t think CPI will ever go below 4 – lobbies are quite strong and active in India). Kotal Mahindra offers almost equivalent IR on savings account :P

    3. Dr. Zaid……

      IIB gives you only 1.44%……..but your principal amount would increase by 4%. For example: you invested 100 in these bonds which carry 1.44% interest rate. Now, next year when inflation is 4% then your principal would increase by 4% and on this increased principal you would get 1.44%. Next year if inflation is 5% then, your principal 104 is increased by 5% and on the increased amount 1.44% is given. You may note that every year/ quarter your principal amount is adjusted to inflation…the interest rate remain same but interest amount would increase.

  14. Nice article……. Thanks mrunal sir

  15. mrunal sir Can you explain Net Asset Value, Price to Equity ratio.

    1. Net asset value (NAV) is generally use to quote Mutual funds. The concept is simple….suppose a mutual fund company has sold 10000 mutual fund policies….and it collected Rs.100000 (10/policy). Now, it invests this amount in reliance share and purchases…1000 shares at 100 per share. Therefore, Its assets are nothing but reliance share and its value is 100*1000=10000. Tomorrow, reliance price comes down to 90….so, your asset value is not 90*100=90000. when you distribute this 90000 over 10000 policies that you have sold…then each policy would get 9…..this 9 is NAV.

      Price to equity ratio is…….Market price of share divided by the book value of the equity. Market price you can observe directly in the stock market…but what is the book value of equity??? Book value of equity is nothing but total assets minus all outside liabilities (which includes loans and other funds raised from outsiders) and this gives you how much owners have invested in the company. When you divide the how much owners have invested in the company by the number of shares issued then you will get the book value of equity.

      Usually it is observed that market price will not be equal to book value……this is mainly due to growth opportunities that firm is facing…..market price is determined by the future growth of a company while book value is nothing but the historical value of how much owners have invested in a company.

  16. Very nice article help me alot

  17. Mrunal sir ap mere comments block kyo kr de rhe hai?

  18. plz can anyone explain,what is juntaa??

    1. Aam aadmi alias mango ppl like u and me.

  19. MRUNAL SIR,

    INSSC does not allows NRI to invest in it..

  20. Sir I AM NEW FOLLOWER OF YOUR FABULOUS WORK, I WANNA KNOW IF YOU HAVE THREADED AN ARTICLE ABOUT COMPILATION OF ARC REPORT, IF NO CAN YOU PLEASE WORK ON THAT TOO WITH BEAUTIFUL VIEWPOINTS AND IF YES CAN ANYONE SEND ME THE LINK.

  21. Sir whenever i click on assign a menu…it is showing the page of wordpress.com …..how to sign in and sign up

  22. Very good article Mrunal……Very informative also.

    But there is one small misinformation in the article……The way you treated inflation is some what different from the way they actually treat it.

    The basic difference is that…… inflation is adjusted in the principal amount and interest rate remains the same at the quoted rate…..so, if inflation is 9% then the principal amount would increase to 10900(if the face value is 10000) and on this 10900, 1.5% interest is paid. This method will take care of the compounding effect of the inflation…..which is very important as inflation is calculated over last year’s base.

  23. What is meant by disclosure of interest by ministers?

  24. nicely explained sir jee..appreciable :-)

  25. sir,how do i start with economy as my mains subject..please suggest books and approach..

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