Nearly two and a half years after the Reserve Bank of India (RBI) released a technical paper on the instrument, Inflation Indexed Bonds (IIBs) are finally here. The RBI has set the launch on June 4, 2013, which will mark the first issuance of the bonds, and has also detailed the terms of issuance. These instruments will have a fixed real coupon rate and a nominal principal value that will be adjusted against inflation. Semi-annual coupon payments will be made on the adjusted principal so that these bonds provide inflation protection to both the principal and interest. At maturity, the adjusted principal or the face value, whichever is higher, will be paid to the investor.
IIBs will be issued via auctions like other gilt securities and in order to promote retail participation, the non-competitive bidding portion will be increased from the standard 5% to upto 20% of the notified amount of the auction. The bonds will have a tenor of 10-years, each issuance tranche will be Rs 1,000-2,000 cr and for the fiscal year the total issuance will be Rs 12,000-15,000 cr. This total quantum is part of the annual borrowing programme but over and above the half yearly borrowing calendar. Thus, it will not increase the overall market borrowing by the government which was announced in the Union Budget earlier this year. Subsequent to the first issuance on June 4, these bonds will be issued on the last Tuesday of every month including the last Tuesday of June.
An IIB will be treated like any other government security, which means that among other things, it will eligible as a Statutory Liquidity Ratio (SLR) security. For the purpose of taxation, the RBI holds that the current rules that apply to any of the instrument will equally apply to IIBs and there will not be any special provisions for the same. Since tax rules come under the purview of the government, it will be the final authority to take the final decision on the issue.
In order to build liquidity, the same bond will be re-issued throughout the first half of the fiscal. In the primary auction, the minimum bidding amount for an individual would be Rs 10,000 and can go upto Rs 2 cr in the non-competitive bidding segment. No such limits have been set for individuals for transaction in the secondary market. Also, there will not be any floor (minimum) on the IIB coupon.
For retail investors, a demat or gilt account is necessary, at least for the first series of bonds. The central bank is also planning to launch a special series of bonds only for retail investors in October 2013 and is thinking over various options for sales and mode of holding of the same.
Foreign Institutional Investors (FIIs) are allowed to invest in these securities within the prescribed limits of $25 bn of government debt. Inflation bonds will also be eligible for short-selling, repo transactions.
For the purpose of coupon payments, redemption payments and accrued interest of an indexed security, an index ratio is used. This ratio, which will be provided daily, will be computed by dividing the reference index for the settlement date by the reference index for the issue date. The reference index in this case will be the headline Wholesale Price Inflation (WPI). The RBI maintains that it may move over to the more representative Consumer Price Inflation (CPI) once that index stabilizes.
The indexation will be done with the final WPI and the RBI has given a 4-month lag for the availability of this figure. In its December 2010 technical paper, the RBI had laid out its reasons for using the WPI. It had said that the frequency of the WPI has been changed from weekly to monthly since November 2009 making it more suitable for indexation. Further, the base year of the WPI has been updated from 1993-94 to 2004-05 along with broadening the basket to incorporate more items from both organised and un-organised sectors.
The selection of the WPI over the CPI has caused a lot of resentment across the investment industry and for good reason. The common man, for whom this product is intended, is affected by the CPI rather than the WPI. And there is quite a difference between the rates of growth of the two. Whereas the WPI crept up by 4.89% on-year in April 2013, the CPI raced at a 9.39% pace. But this should not be considered as the Achilles’ heel of IIBs, especially at this early stage, in light of the fact the RBI itself is unsure of the acceptability of the bonds and is seeking more stability in the CPI before that index can be used for indexation purpose.
The central bank had briefly tested the indexed bond waters once before when it had issued Capital Index Bonds, 2002 on December 29, 1997. These instruments had only their principal repayments at the time of redemption indexed to inflation. And the response to the issue was subdued as interest payments were not protected against inflation. Thus, IIBs come as an improvement on the erstwhile CIBs. Further, to make sure that the revisions in the WPI are accounted for, the index will be used with a 4-month lag. For example, the final WPI for January will be taken as reference for June 1 and the final WPI for February will be used as reference for July 1.
There is another concern, that of allowing institutions in an offering which is supposed to benefit retail participants. On that account, it should be noted that since it is a new offering, the interest from the retail segment of investors would be hard to gauge and due to this the liquidity may be low, thus restricting trading. The central bank itself maintains that ‘for appropriate price discovery and market development, it is necessary to issue comparable instruments through auctions to the institutional investors such as Pension Funds, Insurance, and Mutual Funds etc. This will create demand for IIBs and help in making them tradable in the secondary market.’
But it is equally necessary that on its part, the RBI should make sure that the series of retail bonds that it intends to launch in October 2013 should be well though out in terms or availability and ease of trading, especially after price discovery by institutions and a study of retail interest in the non-competitive bidding segment during the first half of the fiscal. Also, the move towards CPI, even if gradual, should be treated as writing on the wall so that over a passage of time, these bonds can actually protect the middle class against the strains of consumer inflation. The taxation perspective is beyond the central bank’s scope, but if it strives for favourable measures for retail investors, it will ensure that the introduction of these securities does not turn out to be just another damp squib.
Appreciation and/or criticism for the regulator can wait; for now at least, it’s a start.