India’s foray into IIB (Inflation Indexed Bonds) has been disastrous. IIB were supposed to provide a hedge against inflation for investors but in fact it has wiped out capital for the early buyers of the bond.
The latest IIB auction for Rs 1000 crores held on the 27th of August 2013 saw the cut off price on the IIB at Rs 83.30 at yield of 3.47%. The IIB went on to trade at a price of Rs 81.49 at a yield of 3.716%. The first IIB auction for fiscal 2013-14, held in June 2013 saw the cut off yield at 1.44% for a Rs 100 face value bond.
The IIB has lost 18.50% in value since issuance in June. The primary reason for the market shunning IIB is the sharp rise in cost of holding the bond. The RBI moves towards tightening of liquidity in the system pushed up funding costs to levels of 10.25% from levels of 7.25%. A bank holding the IIB was earning a negative carry of 8.81% (10.25% – 1.44% ). The bank requires the price of IIB to rise by 8.81% to negate the negative carry cost.
The price at Rs 81.50 levels for the IIB may look cheap but the yield on the IIB at 3.7% is still too low for banks to hold the bond in times of high funding costs. However if funding costs are expected to come off, the market may punt on the IIB given its low absolute value.
Funding costs can come off only if the INR stabilizes and that does not seem likely in the near future. IIB holders will continue to bleed until then.