Rising inflation is one of the main concerns for any government, central bank, corporate or public at large, as it affects the purchasing power of consumers, profitability of businesses, and stability of financial markets. Inflation is the sustained increase in the general price levels of goods and services in any economy over a period of time and is usually measured by using the Consumer Price Index.

To protect against rising inflation, many countries issue debt securities linked to inflation. In the United States, inflation-indexed bonds referred to as Treasury Inflation-Protected Securities have a total outstanding of $377 billion as on Mar 1, 2023.

Other countries that have issued inflation-linked securities include the United Kingdom, Canada, France, Australia, Italy, Spain, Brazil, and India. However, the issuance of inflation-indexed bonds or capital-indexed bonds has been limited in India and is yet to find investor acceptance.

What Exactly Are Inflation Indexed Bonds?

Inflation-indexed bonds or capital-indexed bonds are a type of floating rate bonds linked to inflation indices such as the wholesale price index and consumer price index in India. These securities are issued to protect investors from the adverse effects of rising prices. Both face value and coupon are measured against inflation for capital or inflation-indexed bonds.

Inflation component on principal will not be paid with interest, but will be adjusted in the principal by multiplying principal with index ratio. At the time of redemption, adjusted principal or the face, whichever is higher, would be paid. Interest rates will provide protection against inflation by paying a fixed coupon rate on the principal adjusted against inflation.

The below example provided by the Reserve Bank of India explains the concept of inflation-adjusted principal and coupon payments when inflation.

As per the above table, the face value of the inflation-indexed bond is ₹100 and the coupon rate is fixed at 1.50%. The inflation index is considered as 100 at the issuance of these bonds, then for that first-year coupon will be 1.50. If the inflation index increases to the 106 level next year, then the principal amount is adjusted to inflation and the coupon payment will be 1.59%.

At the time of maturity, the principal amount is adjusted to inflation and ₹160.2 is paid instead of the initial face value of ₹100 and the interest component has also increased to 2.40% in the last year.

Issuance of Inflation Indexed Bonds in India

The Reserve Bank of India introduced capital-indexed bonds in 1997 on behalf of the Government of India that provided inflation protection only to the principal amount and not the coupon payments. The Reserve Bank of India experimented with this capital-indexed bonds issue in December 1997 with a 5-year tenure. However, the response was lukewarm and there has not been any capital-indexed bond issuance since then.

New inflation-indexed bonds with protection to both principal and interest payments were introduced in June 2013 by the Reserve Bank of India linked to the Wholesale Price Index and another tranche of inflation-indexed bonds was launched in December 2013 specifically for retail investors linked to the Consumer Price Index. The securities issued in 2013 for retail investors were called inflation-indexed National Savings Securities for a 10-year tenure.

Retail investors could invest a minimum amount of ₹5,000 and a maximum amount of ₹1 million per year in the inflation-linked investment bonds. However, inflation-indexed bonds also did not get wider acceptance and were discontinued after the initial issues.

The Government of India has repurchased most of these bonds. Currently, the outstanding on inflation-indexed bonds that mature in June 2023 is ₹227.7 million. Corporate have not issued any inflation-linked bonds in India so far.

Benefits & Risks of Inflation Indexed Bonds

Inflation-indexed bonds serve as a hedge against price increases. These bonds are less volatile than other bonds and the risk involved with uncertainty is reduced. Also, these bonds are issued by the Reserve Bank of India on behalf of the Government of India, thus eliminating the credit risk as government securities are considered risk-free securities.

Investing in inflation-indexed bonds could help investors diversify their portfolios and conservative investors prefer these bonds to protect their capital from rising prices.

There are certain disadvantages as well. These bonds may carry interest rate risk because if interest rates in the economy rise and other bonds may offer higher coupon rates thus reducing the earning potential. The inflation-indexed bonds do not have any special tax treatment and taxes will be applicable for interest payment and capital gains, reducing the net yield for investors.

Sources: Reserve Bank of India, Media Reports, US Federal Reserve