Fiscal 2013-14 will see the government testing the market for IIBs (Inflation Indexed Bonds). IIBs will be issued as part of the government borrowing program and it will also be issued to small savers as an alternative to the NSC (National Savings Certificate).
IIBs were first issued in 1997 after which it was discontinued. The 1997 IIB issuance was in the form of CIB or Capital Index Bond where only the principal repayment was indexed to inflation. The current CIB version of IIBs will protect interest payment as well as principal repayment from inflation.
Inflation for the purpose of IIBs
Inflation for the purpose of IIBs will be the WPI (Wholesale Price Index base year 2004-05). The WPI used for calculating the Index Ratio, which is the inflation rate for the purpose of indexing, will be the final WPI. The final WPI is released after a lag of two and half months from the date of first release and for the purpose of calculating the Index Ratio two consecutive final WPIs are required. Hence WPI used for calculating the Index Ratio will be four months old. For example if Index Ratio is being calculated in August, WPI for months of April and May will be the reference inflation index.
How do the IIBs work?
IIBs have a par value, tenor and interest rate. The interest payment and par value will reflect the rise or fall in inflation. Let us take an example.
IIB is issued on 8th March 2012 at a par value of Rs 100 for a maturity period of ten years and carrying an annual interest rate of 5%. The WPI for the purpose of fixing the interest rate on the IIB is a WPI index level of 100
The first interest payment on the IIB is due on the 8th of March 2013. What will the IIB holder receives as interest payment? The reference WPI on the 15th of March is 107.5. Inflation was 7.5% over a one year period. How will the IIB holder be compensated for the rise in inflation
The first step for calculating the interest payment is to calculate the Index Ratio.
Index Ratio = Reference WPI on the interest payment date / Reference WPI on the issue date.
Reference WPI on Interest Payment Date = 107.5
Index Ratio= 107.5/100 = 1.075
Par value of the IIB on issue date= Rs 100
Par Value of IIB on Interest Payment Date = Par Value of IIB on Issue Date * Index Ratio = Rs 100* 1.075= Rs 107.5
Interest rate on the IIB = 5%
Interest payment the IIB holder receives on the 8th of March 2013 = 5%* Rs 107.5= Rs 5.375
The IIB holder is thus compensated for the rise in inflation through higher interest payout.
The rise in par value of the IIB adjusted for inflation compensates the principal of the IIB holder against inflation.
What are the issues on IIB?
The issues on IIB in India would be
- The relevance of WPI as the reference index given the structural issues surrounding the index in terms of data collection, components etc.
- Lack of real yield curve hampers the price discover of IIBs and might lead to incorrect fixing of yields at the time of issuance
- Liquidity could be low if market has doubts on its inflation forecasting ability
- The wide gap between WPI and CPI (Consumer Price Index), which is currently at around 3.5% leads to doubts on the IIB holder being compensated for true inflation in the economy
- Change in WPI components and base years will affect IIB holders
RBI publication on Inflation Indexed Bonds dated 9th December 2010 gives out the form of the IIBs that would be issued in India. RBI has discussed the modalities of issuance of IIBs by the government as part of its borrowing program and has gone into more technical details of bidding for IIB auctions, settlement price of IIBs, rounding off the Index Ratio etc.
The structure of IIBs for small savers have not been put out but the principal of the IIB will be as per the RBI publication.
On 4 June 2013, the RBI will auction the first tranche (Rs 1,000-2,000 crore) of inflation-indexed bonds (IIBs) with a maturity of 10 years. IIBs worth Rs 12,000-15,000 crore will be issued during the current financial year (FY 2013-14). These will be divided into tranches and auctioned on the last Tuesday of every month. IIBs with different maturity periods will also be issued.
Here is the help for understanding the inflation indexed bonds (IIBs).