Index-linked bonds may have gilt-edged future
The government’s plan to reintroduce inflation-indexed bonds is being seen with some interest as previous issuances were not successful for a wide variety of reasons.
The most recent case in hand was the wholesale price index (WPI)-based bonds that failed miserably in the market after inflation rapidly started sliding, and the Reserve Bank of India (RBI) adopted consumer price index (CPI)-based inflation for its policy formulation. The government had to buy back ~65 billion of bonds two years down the line after they were issued in 2013. The original maturity of the bonds was 10 years.
The government had also launched capital indexed bonds in 1997, but as the name suggests, the protection was on the capital, not on the interest. The WPI bonds had inflation protection on interest as well. The new series could likely be an improvement on the WPI bonds, with much better protection level for investors.
The bonds offered 1.44 per cent of annual coupon, over and above the prevailing WPI level. But in 2014, the WPI inflation turned negative and continued for 15 months, wiping out whatever gain the bond holders had in mind. Now, the government says that about 10 per cent of the ~2.88 trillion of first half borrowing
programme will be raised through the CPI-indexed bonds and through floating rate bonds. While this will significantly cut the duration risk of bond investors, it remains to be seen if there would be interest among banks to buy these bonds.
“It is difficult to ascertain the valuation of these bonds; coupon could be less and trading is a
problem,” said Devendra Dash, head (asset liability management), AU Small Finance Bank.
Moreover, the RBI now targets CPI inflation and is committed to keep retail inflation checked at a maximum of 6 per cent. It is not clear yet how much the coupon would be set for these bonds, but given past experience, a spread of 1.5 per cent above inflation could be low at a time when interest rates are rising.
“But the bonds could be a good investment for retail investors, if the product construct is suitable enough,” said Joydeep Sen, financial advisor and partner of Sen & Apte Consulting.
“This product is an ideal instrument for retired people. If the government can manage to give a higher mark-up over inflation for senior citizens than other investors, this product can be very useful,” said Sen.
“But it is difficult to make lay investors understand the concept of CPI. Besides, retail investors also do not like expose themselves in uncertain territories, guessing the inflation trajectory,” said Dash.
The WPI inflation bonds gave rise to a number of interesting derivatives. At least one mutual fund house developed a wealth management product for its clients based on the WPI-linked bonds. But the timing of the launch was wrong. It was launched at a time when inflation was high. By next year, the base effect had pulled down the index and it soon turned negative. The secondary market of these bonds collapsed soon.
“Both the government and the RBI have to nurture this instrument and create more liquidity for it to succeed. Otherwise, inflation bonds cannot become popular on their own,” said a senior bond trader with a primary dealer.