Inflation indexed bonds will be issued by Reserve Bank of India soon. In the initial phase inflation indexed bonds will be offered through auction method. Later they may be offered as National Savings Certificates. Retail investors can purchase these through primary dealers. Out of several variables in Inflation indexed bonds, Capital Indexed Bonds are proposed to be issued in India. Capital Indexed bonds (CIB) are very popular instruments all over the world. Inflation protection offered to investors on principal and calculation of semi annual coupons payment will be based on Wholesale Price Index (WPI). The WPI for all commodities (Base 1993-94=100) is used for this purpose. Selection of WPI as inflation index is suitable as it is widely available for public, published more frequently, fulfill hedging needs of both investors and issuers (Government), closely tracks inflation in India which is widely accepted.
The main purpose of inflation indexed bonds is to offer investors a reliable way to protect their investments against inflation. Recently Government is trying hard to restrict gold imports which consumes huge foreign exchange reserves by hiking duties and other methods. But still it is futile as most investors see gold as a good hedging instrument. For such investors, these inflation indexed bonds may be a good alternative.
– Offered through auction method with bidders to quote required yield prior to adjustment of inflation factor (Real Yield) up to 2 decimals.
– First issuance of these Capital indexed bonds may be at par value of Rs 100. Reissued bonds price may be at par , below par or above par.
– Wholesale Price Index (WPI) with 1993-94=100 is used as inflation index for determining inflation adjusted capital value. Reference WPI is adjusted weekly average of the fifth preceding calender month. For Example Reference WPI for June will be average of WPI for the month of January.
– Out of the two indexed processed widely used around the world (Canandian model and UK Model), Candian model will be used for applying indexation lag. Least the lag more realistic are inflation calculations to present situations. In UK model the lag is 8 months. In India, as canadian model is used, accrued interest is is factored in in ‘index ratio’.
– Coupon interest will be paid semi annually and is based on inflation adjusted principal amount. Thus the value of principal can be above, below or at par during interest payment period. Anyhow, during maturity time, Capital indexed bonds are redeemed at inflation adjusted principal or original Par Value whichever is higher. It means inflation adjusted capital is not payable until redemption and is used for calculation of semi annual coupon interest.
– Semi annual coupon rate is determined at auction will be used throughout the bond period for calculation of interest payable. As principal is adjusted for inflation, no need to change coupon rate.
Calculation of inflation indexed bonds
Here is an illustration (Source : RBI Publication report on capital indexed bonds (Inflation indexed bonds))
A 10-year CIB with coupon of 3% was issued on July 15, 2003, with the first interest payment due on January 15, 2004. The Ref WPI on July 15, 2003 (Ref WPI Issue Date) was 120, and the Ref WPI on January 15, 2004 (Ref WPI Date) was 132. For a par amount of Rs. 1,00,000 the inflation-adjusted principal on January 15, 2004 would be Rs.1,00,000 x 132/120 = Rs. 1,10,000.
The semiannual interest payment for the bonds would be calculated by multiplying the inflation adjusted principal amount with the applicable coupon rate (i.e. half of 3 per cent) as under:
Rs. 1,10,000 x 0.03/2 = Rs.1,650.00
In the same example, if the Ref WPI on January 15, 2004 was 115, the inflation adjusted principal on that day would be
Rs. 1,00,000 x 115/120 = Rs. 95,833.33
and the semi annual interest payment, accordingly, would be
Rs. 95833.33 x 0.03/2 = Rs. 1437.5
For detailed calculations and explanations one can refer above source and technical paper on inflation indexed bonds by Reserve Bank of India