It’s all about inflation-indexed bonds (IIB)

Inflation is always bringing problem to normal person but this time Inflation may provide you benefit Yes Inflation Indexed Bond (IIB) is another financial product which will be launched on June,4, 2013 with a maturity of 10 years. The intention behind the launch of IIB is to provide real returns to investors and reduce physical gold buying binge. Let’s check out details about IIB.

Meaning of IIBs:

IIB is debt instrument which attempt to give return higher than inflation rate if it is held up to maturity. Investors seeking safe returns with little to no risk will often hold inflation-indexed securities. In other words, an inflation-indexed security guarantees a real return. Here principal amount is linked to the inflation rate so that the impact of inflation on the capital amount is reduced.

Inflation Indexed Bonds will have a fixed real coupon rate and an adjustable principal value indexed by the inflation benchmark chosen. During every interest payout, the face value of the bond gets adjusted with the Reference inflation numbers and the interest amount is calculated from the adjusted figures. Hence, the interest amount is also linked to the inflation. At maturity, the adjusted principal or the face value, whichever is higher, will be paid. Thus these bonds provide inflation protection to both principal and coupon payment.

Regular Bond versus IIBs

Let us illustrate the difference between a regular bond and an IIB with an example. Assume that both bonds have a face value of Rs 1,000, a tenure of five years and a coupon rate of 10% per annum payable annually. The table on the left shows the difference in the cash flow from these bonds.

The regular bond continues to pay Rs 100 to the bondholder till maturity, irrespective of the inflation rate, whereas the IIB adjusts its interest payments depending on the inflation rate. As the inflation rate changes every year, so does the cash flow from the IIB.

The other advantage of the IIB is that it not only adjusts the interest payments to inflation but also the principal repaid to the investor at the end of the bond’s tenure. In the final year, the higher of the original principal or the inflation-adjusted principal is paid to the bond holder The benefit of an IIB over a regular bond is clearly visible in the higher internal rate of return (IRR) for the investor.

Flipside of IIBs

Although inflation-indexed bonds prove beneficial during times of high inflation, they underperform when the economy goes through a deflationary phase and prices actually come down. In such a situation, the IIB will give lower than the coupon rate because the principal would get adjusted below Rs 1,000. However, this is only a theoretical risk. Practically IIB seems to advantageous compare to normal bonds.

When can IIBs work for you?

You see in an inflationary scenario, where prices are on a rise and have an effect of eroding the value of hard earned savings, IIBs can work well for you. But during deflationary phase, they may not yield you much luring returns since them being linked to WPI inflation.