What are Inflation-Indexed Bonds? Know Here!

Key Highlights

• Inflation-indexed bonds are designed to shield investors from the eroding effects of inflation on their investments.
• The principal amount of these bonds adjusts based on changes in the inflation rate.
• While the principal adjusts with inflation, inflation-indexed bonds typically offer a fixed interest rate.
• Governments often issue these bonds, offering investors a tool to hedge against inflation.

What are Inflation Indexed Bonds?

Inflation-indexed bonds, also known as IIBs, constitute a specific type of bond crafted to provide investors with protection against the escalating effects of inflation, characterised by the gradual increase in the overall price level of goods and services within an economy. The detrimental impact of inflation on the purchasing power of money and its potential to create economic instability necessitate measures to counteract these effects. In this context, inflation-indexed bonds act as a safeguard against inflation by offering a fixed rate of return that accommodates changes in the inflation rate. Both the principal amount and interest payments associated with these bonds undergo adjustments to preserve their real value, ensuring that investors' holdings remain insulated from the adverse impacts of inflation.

History of Inflation-Indexed Bonds

Inflation-indexed bonds trace their conceptual roots to 1780, when the Massachusetts Bay Company issued the first known inflation-linked security. However, modern adoption began in 1981, when the United Kingdom launched Index-Linked Gilts, tying returns to the Retail Price Index to protect investors from inflation erosion. This innovation spurred global interest, especially among sovereign issuers seeking to stabilise real returns and diversify debt portfolios.

The United States introduced Treasury Inflation-Protected Securities (TIPS) in 1997, indexed to the Consumer Price Index (CPI), offering semi-annual interest payments adjusted for inflation. These became a cornerstone for pension funds and long-term investments. By 2019, inflation-linked bonds represented over $3.1 trillion globally, with sovereign issuers dominating the market.

India entered the space in 2013 with its own Inflation-Indexed Bonds, initially targeting retail investors and later institutional buyers. These were linked to the Wholesale Price Index (WPI), later revised to Consumer Price Index (CPI) for better alignment with consumer inflation.

How Inflation-Indexed Bonds works?

Inflation-indexed bonds function differently from conventional bonds, particularly concerning their interest payments. The principal amount and interest payments undergo adjustments based on inflation, utilising the Consumer Price Index (CPI). This adjustment ensures that the real value of the investment is preserved. Typically, a fixed interest rate is established at the bond's issuance, and this rate is combined with the inflation rate to determine the total interest payment. To illustrate the workings of Inflation-Indexed Bonds, consider an example: Assume an investor acquires an IIB with a face value of ₹10,000, a ten-year maturity, and a coupon rate set at 3% above inflation.

In the first year, if the inflation rate is 4% at the bond's issuance, the investor receives an annual interest payment of ₹312 (3% of ₹10,400).

Should the inflation rate rise to 5% in the second year, the investor would then receive an annual interest payment of ₹327.60 (3% of ₹10,920). Importantly, the coupon rate remains consistently set at 3% above the inflation rate throughout the entire ten-year duration. This process persists until the bond matures, ensuring that the investor receives a fixed income stream that dynamically adjusts to keep pace with inflation, thereby offering a hedge against the eroding effects of rising prices over time.

Examples of Inflation-Indexed Bonds

Here are the detailed examples of how these bonds work:

Example 1: Principal Adjustment

Suppose you buy an inflation bond worth ₹1,000 when the inflation index (CPI) is 100.

After one year, inflation rises by 6%, so the CPI becomes 106. Your bond’s adjusted principal becomes: ₹1,000 × (106 ÷ 100) = ₹1,060.

Now, interest will be calculated on ₹1,060, not on the original ₹1,000.

If the coupon rate is 4%, the annual interest you receive is:

₹1,060 × 4% = ₹42.40.

Thus, your returns increase in line with inflation.

Example 2: Deflation Scenario

Assume inflation falls and CPI decreases from 106 to 103 (a 2.83% fall). Your adjusted principal becomes:

₹1,060 × (103 ÷ 106) = ₹1,030.

Interest is calculated on ₹1,030 at 4%, which equals ₹41.20. Even though the pay-out falls slightly, the principal at maturity never drops below the original ₹1,000, ensuring the safety of capital.

Example 3: Long-Term Protection

If inflation averages 5% annually for 10 years, the bond’s principal of ₹1,000 grows to nearly ₹1,629. With a 4% coupon, your annual interest in the 10th year will be about ₹65, far higher than the ₹40 you would have received without inflation protection.

Types of Inflation-Indexed Bonds

The three common types of inflation-indexed bonds are:

• Capital Indexed Bonds (CIBs):

Capital indexed bonds are structured so that only the principal is adjusted in line with inflation. The interest payments, also called coupon payments, remain fixed throughout the tenure. At maturity, the principal repayment reflects inflation-adjusted value, ensuring the investor’s capital does not lose purchasing power.

• Interest-Indexed Bonds:

Interest-indexed bonds link the coupon payments to an inflation index while the principal remains constant. The interest rate is adjusted periodically in line with inflation, ensuring that periodic income reflects rising prices. For instance, if the bond carries a base interest of 4% and inflation increases by 5%, the coupon payment is recalculated to include the inflation component, resulting in an effective 9% pay-out. However, since the principal does not change, protection is limited to the income flow.

• Principal and Interest-Indexed Bonds:

Principal and interest-indexed bonds combine both features, where the principal is adjusted for inflation and the coupon is calculated on the revised amount. This dual adjustment provides comprehensive protection as both capital and income grow in line with inflation.

Features of Inflation-Indexed Bonds

1. Inflation Protection: The purpose of index-linked inflation bonds is to protect investors' tangible assets from the depreciating impacts of inflation.

2. Flexible concept: To protect the actual value of the investment, the principal amount of these bonds is modified in response to variations in the inflation rate.

3. Interest Rate Adjustments: Interest payments are tied to inflation; the total interest payment is usually calculated by adding a fixed interest rate to the inflation rate.

4. Consumer Price Index (CPI): The Consumer Price Index (CPI), a widely used indicator of inflation that considers changes in the price of a basket of goods and services, is frequently used to make inflation adjustments.

5. Government Issued: Governments typically issue inflation-indexed bonds as a financial instrument to raise capital while providing investors with a hedge against inflation.

How do you calculate the interest on an inflation-indexed bond?

To calculate the interest on an inflation-linked bond, you need to adjust the bond’s principal value with inflation before applying the coupon rate. The interest is not calculated on the original principal but on the inflation-adjusted one.

Here’s the step-by-step calculation:

• Start with the original principal, say ₹1,00,000.

• Check the inflation rate using the CPI. Suppose the inflation is 4%.

• Adjust the principal: New Principal = ₹1,00,000 × (1 + 0.04) = ₹1,04,000.

• Apply the coupon rate: If the bond has a 5% coupon, then Interest = 5% of ₹1,04,000 = ₹5,200.

So, instead of earning ₹5,000 (on the original principal), the investor earns ₹5,200 because of inflation adjustment.

Should You Invest in Inflation-Indexed Bonds?

Investing in these bonds is beneficial for the following reasons:

• Inflation-indexed bonds adjust both principal and interest payments according to inflation levels, measured by the Consumer Price Index. This ensures the real value of the investment is maintained, making them suitable for investors seeking protection against long-term erosion of purchasing power.

• Unlike fixed-rate instruments, these bonds provide guaranteed real returns above inflation. Even when inflation rises sharply, investors continue to earn an assured margin.

• These bonds are typically issued for longer tenures, encouraging disciplined long-term investing. Since returns are linked to inflation, volatility caused by sudden price level changes is neutralised.

• Principal value in inflation-indexed bonds increases with inflation, reducing the risk of erosion. For investors with long horizons, this feature ensures that the invested capital retains its actual worth, safeguarding against monetary depreciation, which is often overlooked in fixed-return products.

• Traditional bonds lose value when inflation leads to rising interest rates. Inflation-indexed bonds, however, shield investors from this risk as coupon payments move in line with inflation.

• Including inflation-indexed bonds in a portfolio adds a hedge against inflation-driven volatility. Equity and fixed-income instruments often struggle during inflationary pressures, but these bonds counterbalance losses.

How to Invest in Inflation-Indexed Bonds?

Investors can acquire inflation-indexed bonds, including government websites, banks, and brokerages. In India, the primary methods for purchasing these bonds are through Inflation Indexed National Saving Securities - Cumulative and Index Funds. These bonds, issued by the Indian government, serve as a tool to help savers safeguard their money from the eroding effects of inflation. Purchases can be made through banks, brokerages, and online platforms, giving investors flexibility.

Inflation-Indexed Bond Benefits:

1. Maintenance of Purchasing Power: By guaranteeing that the actual value of their investment will be maintained, investors can lessen the adverse effects of inflation on their purchasing power.

2. Continuous Real Returns: Investors can receive a constant income stream adjusted for changes in the cost of living through index-linked inflation bonds, which offer a source of returns that keeps up with inflation.

3. Diversification: Including inflation-indexed bonds as a counterbalance to other asset classes in a diversified portfolio can be a risk management tactic, particularly in inflationary times.

4. Government Assistance: These bonds offer investors a reasonably safe investment choice since, being government-issued securities, they frequently have a high creditworthiness rating.

5. Predictable Income: Fixed interest rates, coupled with adjustments for inflation, contribute to predictable income for investors, enhancing financial planning and stability.

6. Long-Term Consideration: Suited for investors with a long-term perspective, inflation-indexed bonds become more advantageous over extended periods as they consistently address the impact of inflation on returns.

Things to Keep in Mind Before Investing in Inflation-Indexed Bonds

Before investing in these bonds, a few things investors must know are:

• Interest Calculation: The interest pay-out on Inflation-indexed bonds is based on the inflation-adjusted principal, not the original face value. This ensures that the return reflects prevailing inflation trends. For example, if the coupon rate is fixed at a certain percentage, the actual interest paid increases when inflation pushes the principal higher. Conversely, when inflation slows or turns negative, the effective pay-out can reduce.

• Liquidity Concerns: While inflation-indexed bonds protect against inflation, their liquidity in the secondary market can be limited. Trading volumes are often low, which means finding a buyer when one wishes to exit early may be difficult. Limited liquidity can lead to wider bid-ask spreads, reducing potential returns if the bond is sold before maturity.

• Tenure Commitment: Inflation-indexed bonds usually come with long tenures, sometimes extending up to ten years or more. This long-term nature restricts flexibility, particularly for investors seeking shorter-term horizons. While the tenure aligns with inflation-protection objectives, it may not suit those who anticipate needing funds earlier. Premature exit options might be available through secondary markets, but limited liquidity makes it difficult.

• Real Yield Understanding: The concept of “real yield” is central to evaluating inflation-indexed Bonds. Real yield refers to the return after factoring in inflation. While these instruments safeguard against rising prices, the real yield can sometimes be low or even negative if inflation-adjusted benefits are modest compared to coupon pay-outs.

Disadvantages of Inflation-Indexed Bonds:

• Low Yields: Inflation bonds typically offer lower yields than regular bonds, potentially diminishing their appeal to investors.

• Limited Availability: Inflation-indexed bonds are not as readily accessible as regular bonds, posing challenges for investors seeking portfolio diversification

• Market Risk: Investing in inflation-indexed bonds carries a degree of market risk, as fluctuations in interest rates and economic factors can impact their prices.

• Liquidity Risk: These bonds may have lower liquidity than regular bonds, making it challenging for investors to sell their holdings when necessary.

• Counterparty Risk: There is a risk of the issuer defaulting on obligations, leading to potential losses for investors.

Conclusion

Inflation-indexed bonds present an effective means for investors to preserve their purchasing power over time. Distinguished by their unique mechanism of adjusting both principal amounts and interest payments in response to inflation, these bonds offer distinct advantages despite certain drawbacks. While investors must be aware of the associated risks, seeking guidance from a financial adviser or conducting thorough research is recommended before considering these bonds for investment. Additionally, the necessity of a Demat account for holding investments in electronic format should be taken into account as part of the investment process.