A lot is happening in the Indian bonds market. Alas, everything at higher levels! Indian G-Secs are having a grand entry into the world’s coveted indices – First in the JP Morgan EM index and now the Bloomberg EM index.

Seems like no one can ignore India anymore. But can India ignore inflation? After a fairly stable decline during 2010-2020, inflation was back after Covid-19 pandemic hit the country in full force. RBI even had to write a letter to the government on why it could not contain inflation within the tolerance band of 2-6% for three consecutive quarters.

The situation is much better now, I must say. The Indian economy is in a good shape with a 4.5% inflation forecast for FY25. Still this figure worries me as an investor. I am only going to get around 7-8% on my fixed income portfolio. If inflation is in the range of 4.5–5%, that leaves me with 2.5-3% of real return. Fair enough, but who can guarantee the future? What if I want to hedge inflation risk?

In fixed income segment, I see no option offering a guaranteed “real return.” Even some financial planners look averse to the idea, as it is mentally hard to comprehend.

Inflation indexed bonds are the type of bonds that promise to pay investors a return after adjusting for inflation. Outside India, of course there are such bonds in existence. That’s when it struck me, why not India?

Well, it is not the case that we did not try. But we failed, that is for sure. Should we give it another try? Let us explore.

Around the world, indexed bonds issuance had crossed $2500 billion by 2017. According to the BIS (Bank of International Settlement) data that I could access on the World Bank website, leading countries issuing such bonds were the US, the UK, Germany, Mexico and Israel.

The share of the inflation linked bonds in total bond market was moderate in most countries.

A part of the reason for this is that it is difficult to understand the concept of break-even inflation. Let us understand this through an example:

Suppose there was one bond with a nominal yield of 7% in your portfolio. Another CPI inflation linked bond with similar features, but real yield of 3% was also there. Both matured after 5 years. In this case, the break-even inflation rate would be (7-3) = 4%.

Suppose during those 5 years, actual inflation that you experienced turned out to be 5%. Thus effectively, your inflation linked bond that provided you 3% real return has outperformed the bond with a nominal 7% yield. (It provided only 2% real yield.)  

Difficult to instantly grasp, right? Still, like all complex financial instruments, linked or indexed bonds have their own advantages.

The most important one being – they help you sleep peacefully without worrying too much about inflation shooting through the roof. That’s what we call hedging the inflation risk.

Sure, as explained above – even if these bonds are linked to CPI, there will be variation in the inflation you actually experience while spending (based on your lifestyle) vis-à-vis CPI figures. Hence, they may not outperform similar nominal rate bond “always”. (Please see the 2nd case where inflation experience is lower at 2.5%)

However, most middle/higher middle income investors investing in these bonds will often experience inflation more than CPI. Index bonds linked to CPI would thus, still make sense to a majority of the investor community.

If so, why did India give up on these bonds? And is another shot at launching them sensible?

For that, let us go back to 1997. (Yes! We made the first attempt more than 25 years ago.) The government issued capital indexed bonds: the 6% Capital indexed bond 2002. They protected the principal amount against inflation, but not coupon payments. Obviously, they tanked.

Second serious attempt came in 2013. By this time, the benefits of indexed bonds had become obvious, for both the government and investors. These new series had inflation protection for both, principal and coupon payments. But, one thing that terribly went wrong here was the actual choice of index. The bonds were linked to WPI, not CPI. Tax treatment, accounting and pricing issues proved to be other obstacles to its success. Institutional investors were not happy.

To add to their woes, RBI moved to CPI in April 2014 and then also adopted the famous 2-6% inflation band in 2016. That made the bonds even more irrelevant. Hence the government quietly accepted their failure and bought them back prematurely.

To be fair, the government had launched indexed bonds in the retail market too. They were based on CPI. [CPI base was the year 2010] Both the 2013 bonds also had a floor rate of 1.5% p.a. – a significant improvement over the older structure. 

However, one drawback still existed. Interest was payable only on maturity. Imagine waiting for 10 years to get your dues! Retail investors did not like it. Since then, we have made no attempt to bring the indexed bonds back.

Three significant improvements can be made, if we were to launch such bonds now.

First, tenure should be shorter, say 5 years.

Second, we will need to solve for taxation troubles. Taxation framework accounts only for nominal gains and we currently have no directives to accommodate real returns sensibly into taxation laws. This matters because during the high inflation phase, these bonds will mop up huge monetary income for the holders, which will be taxable as per current laws. For example: Say CPI turns out to be 7%. Floor rate is 2%. The investor will end up having 9% overall return for that tax year – translating into higher tax liability.

Although it is only fair to pay more when you get more, if we want to incentivise indexed bonds, some tax-related considerations will go a long way.

Another point to note is that – investors have no actual cash in hand until the bonds mature as per the old structure. That brings us to the third tweak required for these bonds.

Third, interest cannot be only cumulative for such long tenured bonds. As with other bonds, we ought to provide some options to ensure investors get regular cash flows.

To sum up…

Somehow, this decade uncannily brings back the memories of the era bygone. Remember the stories of the US economy 100 years ago? of the roaring 20s? They were all about the growth, inflation and rates that stayed higher. Can you see the resemblance to today’s India?

That’s why indexed bonds matter. Stocks and corporate bonds will most probably beat their returns. But indexed bonds will still have appeal because they help us hedge inflation risk while avoiding risk profiles of stocks and corporate bonds. 

After all, investors are more conservative than they like to think. If launched now, these bonds will surely be met with enthusiasm and will have a better chance at survival. Let us see what the RBI and the Government think… until then, let’s keep investing!

Disclaimer: Views or suggestions expressed above are personal opinions of the author. Please consult a SEBI registered investment advisor before investing in bonds or any other investment product.