Inflation Indexed Bonds

An ordinary bond promises a fixed number of rupees. Inflation quietly shrinks what those rupees buy. An Inflation Indexed Bond promises a fixed real return instead.

It does this by adjusting the principal for inflation. The coupon is a fixed real rate, but it is applied to that adjusted principal — so both the interest and the principal rise with prices.

At maturity the investor receives the higher of face value and the inflation-adjusted principal, so a period of deflation cannot take the principal below what was paid.

IIBs (Chapter 6). A category of government securities issued by the RBI. A fixed real coupon rate is applied to the inflation-adjusted principal on each interest date. On maturity, the higher of face value and inflation-adjusted principal is paid.

IINSS-C, 2013 (Chapters 2 and 6) — the retail version:

Chapter 2 adds that the RBI issued no further tranches, citing low retail participation, complexity for retail investors and a period of moderating inflation, and that a large part of the outstanding stock was bought back by the government in 2016.

Role in a retirement plan. Chapter 3, section 3.4.2, lists inflation-indexed bonds with variable and inflation-adjusted annuities, rental income and hybrid funds as ways to give inflation protection to retirement income.

An IIB, one year. Face value Rs 10,000, real coupon 2 per cent, inflation over the year 6 per cent. (Coupon and inflation are illustrative; the mechanism is the workbook's. Annual payment is assumed for simplicity.)

Inflation-adjusted principal = 10,000 × 1.06 = Rs 10,600
Coupon                       = 2% × 10,600  = Rs 212

A plain 2 per cent bond would have paid Rs 200 on Rs 10,000 — and returned Rs 10,000 that now buys 6 per cent less.

Deflation at maturity. If cumulative deflation leaves the adjusted principal at Rs 9,800, the investor still receives Rs 10,000 — the higher of the two.

IINSS-C over its full term. Rs 10,000 invested; suppose CPI inflation averages 6 per cent, so the rate is 1.5 + 6 = 7.5 per cent, compounded half-yearly for 10 years:

Maturity = 10,000 × (1 + 0.075/2)^20
         = 10,000 × (1.0375)^20
         ≈ Rs 20,882

If inflation had instead fallen to nil, the 1.5 per cent floor would still have applied.

Chapter 2, section 2.10.2 (Fixed Income Investments), and Chapter 6, section 6.2.1 (Accumulation Stage Products), both describe IIBs and the IINSS-C, and both flag that IINSS-C is closed and should be read as a historical illustration. Chapter 3, section 3.4.2, names inflation-indexed bonds among the tools for protecting retirement income from inflation. Expect questions on how the coupon and principal are adjusted, what is paid at maturity, the 1.5 per cent / CPI / half-yearly structure, and that IINSS-C is no longer available.

• The real coupon is fixed; the principal moves. The coupon amount changes because it is applied to the adjusted principal.
• At maturity: the higher of face value and adjusted principal. Deflation does not cut the principal below face value.
• IINSS-C is closed. Issued only in 2013-14, never reopened; much of it bought back in 2016. Treat it as history, as both chapters instruct.
• IINSS-C used the CPI. Chapter 2 mentions earlier IIBs linked to CPI/WPI; the IINSS-C figure is CPI.
• Compounded half-yearly and cumulative — not paid out every six months.
• Interest is taxable. Inflation indexation of the return is not a tax exemption.
• The two chapters phrase the IINSS-C return differently — "fixed interest of 1.5 percent over inflation" (Chapter 2) and "fixed interest of 1.5 percent and an inflation rate calculated on the basis of the CPI" (Chapter 6). They describe the same structure.