RBI launched inflation indexed bonds will be available till 31st December. The good news is that the rate will be linked to CPI instead of WPI - the less accurate gauge of inflation. The bad news is that early redemption, even after the lock-in period is over, will entail hefty penalty. Should savers bite into the offering?

The Reserve Bank of India (RBI)’s Inflation Indexed National Savings Securities-Cumulative (IINSS-C) securities are open for subscription till 31^st December. The central bank is using authorised agency banks and Stock Holding Corporation of India (SHCIL) to invest in IINSS-C. The authorized banks are State Bank of India (SBI) and its associates, all nationalized banks, HDFC Bank, ICICI Bank and Axis Bank.
 

The Union Budget of 2013-14 had announced the introduction of instruments that will protect retail savings from inflation. These are internationally known as inflation-linked securities or simply linkers. The distribution/sale of linkers would be through banks, for retail investors. Interest rate on these securities would be linked to final combined consumer price index [CPI (Base: 2010=100)]. Interest rate would comprise two parts: fixed rate (1.5%) and inflation rate, based on three-month lag CPI which will be compounded with the principal on a half-yearly basis and paid only at the time of maturity. So, if a bond is being valued in December, the reference rate will be CPI of September. The issuance of non-cumulative inflation indexed bonds for retail investors will be examined in due course. The minimum and maximum investment per annum is Rs5,000 and Rs5 lakh, respectively. The tenor is fixed at 10 years. The new offering should attract higher attention from savers, especially due to its link to CPI instead of wholesale price index (WPI) which is a less accurate gauge of inflation. In June 2013, RBI sold WPI-linked bonds offering a yield of 1.44% above WPI, but the retail response was dismal. In November 2013, the WPI was 7.52% and CPI was 11.24%. The new offering linked to CPI will fetch 12.74% compared to the WPI-linked bonds that would give only 8.96%; a 10-year bank FD gives approximately 9%.
 

CPI is considered a more accurate gauge of the impact of inflation on consumers because it takes into account increases in the cost of education, food, transportation, housing and medical care; in WPI, the emphasis is on measuring the prices of traded goods and services.
 

Advantages of IINSS-C
 

• Inflation has been high in India in recent years; this bodes good returns and protection from inflation by investment in IINSS-C. The safety of the principal should not be a cause of concern as the bonds are a part of the government’s borrowing programme. IINSS-C will be considered at par with sovereign rated government securities (G-Secs).
 

• Even though IINSS-C will be taxed like fixed-deposits (FD), the interest can be substantially higher than FDs during a period of high inflation. Conversely, the returns can go lower than FDs, when inflation is low. FD rates can also go low when inflation dips and, hence, IINSS-C should be preferred over FD, as long as you have a commitment to stay with the product for a long term. For example, CPI of 11.24% in November 2013 means you can expect to get 12.74%pa (per annum) assuming inflation stays at the same level. With inflation levels fluctuating, the returns from IINSS-C will have a zigzag pattern. Scheduled commercial banks offer approximately 9%pa for 10-year FDs which is guaranteed for the full period.
 

• The product should be easy to purchase from banks; servicing it should not be an issue due to bank involvement. It can be used as collateral for loans from banks, financial Institutions and Non Banking Financial Companies (NBFC). The transferability is limited to nominee(s) on death of holder (only individuals).
 

• IINSS-C can be used to diversify one’s debt portfolio. Their advantage over bonds is that technically the principal is protected in IINSS-C. Selling bonds (taxable or tax-free) during high interest regime can result in getting a price lower than the principal. Early redemption of IINSS-C, after expiry of the lock-in period will ensure that you get back your principal even if inflation falls drastically; but you will take a beating due to the penalty on the coupon rate. It works more like bank FDs which have a penalty on premature withdrawal.
 

IINSS-C is more like FD, less like a bond. IINSS-C surely has an advantage over taxable and tax-free bonds for the conservative saver who does not like the volatility of the investment amount, based on market interest rates.
 

• IINSS-C should dissuade savers from buying gold for investment purposes. Beating inflation with gold has been a fallacy; IINSS-C should be an option for this segment as it will actually make your money grow at a rate higher than inflation. It can be an instrument for retirement savings.
 

Disadvantages of IINSS-C
 

• The bonds are meant to be long-term savings instruments. They will not be tradable in the secondary market. Liquidity is certainly an issue with IINSS-C; bank FDs are completely liquid; some banks do not even have a penalty on premature withdrawals for all FDs or depending on the tenor of the FD.
 

• Early redemptions will be allowed after one year from the date of issue for senior citizens (those above 65 years of age) and three years for all others, subject to penalty charges at the rate of 50% of the last coupon payable for early redemption. For example, if you redeem after the third year, you lose half the interest of the previous year. Early redemptions, however, will be made only on coupon dates. Hefty penalty for early redemption is a major deterrent; but bank FDs too have premature withdrawal penalty of 1% lesser interest rate than the rate offered for the period for which the FD was kept. The calculation of bank FD penalty will be similar to IINSS-C penalty and, hence, there is no reason to overlook IINSS-C. If your investment horizon is shorter than three years, you should not go for this instrument.
 

Read - Inflation Index Bonds Vs Bank FDs – Early redemption penalty decoded

• The Finance Bill of 2012 had lowered the age of senior citizens from 65 years to 60 years for tax benefit purposes. The circular of RBI on IINSS-C, which states that 65 years has to be considered for qualifying as a senior citizen, has brought back the debate on senior citizen’s age.
 

• IINSS-C does not match the charm of public provident fund ( PPF) which allows Rs1 lakh investment in a year for tax deduction under Section 80C. Moreover, interest on PPF is tax free. IINSS-C may not even score over tax-free bonds, especially for savers in the 30% tax bracket. The recent tax-free bonds issues offered coupon rates of 8.66% and 8.76% for AAA and AA+ rated bonds, respectively, of 10-year tenors.
 

• Rate of interest on IINSS-C will be floating which may not be suitable for those in need of fixed income. Moreover, absence of income flow can make the product unattractive for senior citizens. IINSS-C will have half-yearly compounded cumulative offer of 10-year tenor. Bank FD interest is compounded quarterly for the cumulative as well as non-cumulative option.
 

• Tax treatment on interest and principal repayment would be as per the extant taxation provisions. Tax will be levied on the interest as per your tax bracket, which is in line with bank FD. The product is suitable for those in the lower tax bracket (up to 10%). It may work out well for those in the 20% tax bracket, if inflation remains at the current level for much of the 10-year tenor. Some media reports talk about considering payment as capital gains which will lower the tax rate. But, ignore such misinterpretation and calculate tax payment, based on your tax slab.
 

Read - Inflation Index Bonds – How will the taxation impact you?

There are doubts about the true consumer price inflation. If actual inflation is higher, IINSS-C returns will be lower, even in a high inflation regime. Flawed inflation data can be a major worry for IINSS-C investors; but investors, by and large, don’t see costs and returns in inflation-adjusted terms.