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Inflation Indexed Bonds (IIB) announced by RBI : Prima facie a good product

As promised by Mr. Chidambaram in his budget speech few months back, RBI has announced the basic scheme for an Inflation Indexed Bond. The salient features of the same are as under:

- The bonds will have a fixed interest rate
- The principal, however, will be periodically adjusted to inflation based on Wholesale Price Index (WPI)
- Interest will be paid on this adjusted principal
- At maturity, the adjusted principal or the face value, whichever is higher, would be paid
- The bond tenor would be 10 years

Based on the above, IIBs prima facie appear to be a good product. Let's see how.

Suppose the face value is Rs.100, interest rate is 5% and inflation every year is 5%.

Then, if it were a normal non-inflation linked bond, you would receive Rs.5 every year for 10 years and get back your capital of Rs.100 after 10 years. Effective returns - 5%.

But in the IIB, after 1 year the inflation adjusted bond price would be Rs.105. You would get 5% interest on this higher amount of Rs.105 (unlike Rs.100 in a normal bond). Thus you will get Rs.5.25 interest in the first year.

Similarly, at the end of 2nd year, the adjusted bond price would be Rs.110.25 and your interest earning would be Rs.5.51.

If we continue this up to 10 years, then you would receive Rs.5.79, Rs.6.08, Rs.6.38, Rs.6.70, Rs.7.04, Rs.7.39, Rs.7.76 and Rs.8.14 as interest from 3rd to the 10th year.

Further, you will get back Rs.162.89 as inflation-adjusted principal after 10 years.

As you can see, both principal value and interest income increase every year.

Accordingly, the effective returns work out to 10.25%. Not bad!

Of course, the fine print is still awaited and we have to see if there are any devil in the details.

The only drawback at present appears to be the long tenor of 10 years. Hopefully, the bonds would be listed and actively traded to provide good liquidity should anyone need money in the interim.

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