The government and the RBI are considering an issue of CPI (Consumer Price Index) linked IIB (Inflation Indexed Bonds) for small savers. The government has issued IIBs as part of its borrowing program for fiscal 2013-14. The IIB issued at Rs 100 in June 2013 at a real yield of 1.44% is trading at levels of Rs 84.5 at a real yield of 3.28%. The fall in price of IIB should suggest that inflation expectations are coming off but the truth is that the IIB was mispriced initially and with rising funding costs due to hike in rates by RBI, banks found IIBs unviable to hold in their books due to negative carry. Finding cost at 8.5% against coupon of 1.44% is a carry loss of 706 bps for banks.
IIBs are meant to protect the holder from rising inflation expectations. IIBs protect interest payment and capital from inflation. An example of how IIBs work is given at the end of the analysis.
How will the CPI linked IIB be priced?
CPI inflation for month of October 2013 printed at 10.09%. Stripping the CPI of food articles that has a weight of 48% in the index, the core CPI inflation is around 8%. The ten year government bond yield is trading at 9.10%. If the CPI inflation benchmark for the IIB is the overall CPI including food, the real yield works out to a negative 1%. If the CPI inflation benchmark is the core CPI, the real yield is 1.1%.
Let us now assume that the government issues a CPI linked IIB at a real yield of 1.1% as it cannot issue a bond at a negative yield. The yield is much lower than the real yield of 3.28% seen in the WPI linked IIB that is trading in the market. There will be no buyers for the CPI linked IIB at real yields of 1.1% as it is more attractive to buy the WPI linked IIB at 3.28%.
The pricing of the CPI linked IIB is going to be an issue for the government.
CPI inflation will come off – what does it mean for the IIB holder?
The RBI and the Government are keen on bringing down CPI inflation to levels closer to WPI (Wholesale Price Inflation) inflation that is trending at 6.46% levels. The WPI inflation target for the RBI is below 5% levels. CPI is trending at 10.09% levels. A sharp fall in CPI inflation would mean IIB bondholders would not benefit from higher CPI inflation as compared to WPI inflation. The pricing of the CPI linked IIB would then become a key factor in the expected returns on the bond.
The CPI linked IIB bond holder would have to start factoring in a scenario where CPI inflation comes off to levels of 6% in a couple of years time (assuming WPI would be at 5% levels on RBI and Government efforts). The sharp fall in CPI levels, unless compensated by adequate real yields at the time of issuance would eat into the returns of the CPI holder. In fact the investor may be better off buying the ten year bond at a nominal yield of 9.10% (as of 13th November 2013) against a real yield that is much lower given falling inflation expectations. The nominal bond holder would see good price appreciation if CPI does fall to levels of 6%.
How do 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.