Index-Linked Bond
An index-linked bond is such a bond where the interest accrued on the principal amount is linked to a particular price index, usually the consumer price index or CPI. This helps protect the investors from making negative returns by shielding them from changes occurring in the index linked to it. The bond’s cash flows are adjusted so that the investor receives a known real rate of return.
These bonds are usually fixed-rate bonds, and the interest payments, also called coupon payments, are disbursed semi-annually. These coupon payments are adjusted for inflation as they are already linked to an inflation index, such as the CPI or the Retail Price Index (RPI). Hence, the return on these investments consists of the real return and the accrued inflation, thus shielding the investor from inflation. The principal amount, the coupon payment, and the yield are all calculated in real terms instead of nominal terms.
Hence, an investor is aware of the real value of the bond right from the time he invests, the risks involved, making the bonds less volatile and allowing the investor to retain their purchasing power.
Capital Indexed Bonds
The meaning of capital indexed bonds is that the index-linked bonds are linked to an inflation index; they are referred to as capital indexed bonds. The interest amount is paid at a fixed rate on the adjusted face value of the bond. Hence, the investors of these bonds, on maturity, receive the principal amount, the total coupon payment, adjusted as per the inflation index.
Capital Indexed Bonds in India
Previously, in 1997, when the capital indexed bonds were introduced for the first time, they only offered hedging against inflation to the principal amount, and as a result, the coupon payments were exposed to inflation. Hence, both the primary and secondary market participants were not too enthusiastic about this instrument back then, and the lacklustre response forced the government to withdraw it.
The new structure of the capital indexed bonds, introduced in 2004, offer both the coupon payments as well as the principal amount hedging against inflation.
The new structure specifies the coupon rate in real terms, and this coupon rate will be applied to the inflation-adjusted principal in order to calculate the periodic half yearly coupon payments. The principal amount paid would be the greater one of either the original value at par or the inflation-adjusted value. This acts as in-built insurance, as the principal amount does not fall below the original amount invested.
The inflation index linked to the capital indexed bonds is the Wholesale Price Index or WPI, as it is the leading measure of inflation for all commodities in India.
How are capital indexed bonds issued?
Capital Indexed Bonds are issued at auctions through competitive bidding. The bidders are required to bid in their desired real yield terms. Prior to each auction, the specific terms and conditions pertaining to the auction, the auction date, tenure of the bonds, the issue date, and the notified amount would be announced.
The Pros of Capital Indexed Bonds
– These bonds, being indexed to inflation, saves the investor from losing out on wealth to inflation.
– These bonds offer a higher yield than nominal bonds and are less risky and volatile.
– These bonds are tradeable too.
– These bonds are long-term bonds and also offer long term hedging against inflation.
– These bonds are a regular source of income owing to the regular stream of coupon payments.
– These bonds are a great way of diversifying an investor’s portfolio, as there exist many well known issuers of them.
– If banks are cushioned against inflation risk, the benefits might percolate down to the retail investors in the form of higher interest rates. This would provide the retail investors better protection from inflation. Hence, an index more attuned to the consumption levels would be beneficial to the investors.
The Cons of Capital Indexed Bonds
– The best suitable inflation index for these bonds is difficult to determine. Though the WPI is suitable for the Indian economy, it might not adequately capture inflation’s effect on the investors, especially the retail class.
– The inflation index, whichever might be chosen, might be biased.
– Investors are also limited in the choice of an appropriate inflation index.
– The lag in indexation is also a limitation.
– Taxation of these bonds poses a risk if reintroducing some of the inflation risks faced by these bonds.
