A way to make bonds attractive so that investors move away from gold is to provide a tax break on interest to bond-holders
Inflation-indexed bond (IIB) is the new flavour of the season. Two factors have regenerated interest in a product that has been experimented with twice, but failed. First, it is believed that people are buying gold as a hedge against inflation, which is depleting our forex reserves. The logic goes that by providing alternative instruments for savings, which provide cover for inflation, people will migrate back to the financial sector. Second, the Union Budget for FY14 has declared that the government will introduce such bonds to provide such a cushion for investors and the government is trying to push these ideas forward. Evidently, it is believed that there is a strong case again, even though the concept did not quite click earlier.IIBs were introduced with different variants in the past—one which indexed principal only and the other where interest payments were also cushioned. There is a move to have such issuances of G-secs soon to institutional investors to begin with and later bring it down to the retail level. The working of the concept is quite rudimentary. If a bond has a face value of R100 and a coupon rate of, say, 10%. If inflation rises to 10%, then the bond is valued at R110 and the interest paid is R11. Intuitively, it can be seen that in all such transactions there is a zero-sum game involved and if the investor is gaining, then the borrower is losing as additional money has to be paid. Textbooks always say that inflationary times are good for borrowers because they pay negative real rates while lenders are at a disadvantage. So, to begin with, the government will be forking out more money if the scheme takes off. The private sector borrowers will not be too keen to load a cost which is otherwise notional in nature as it will be considered to be quite unnecessary given that no other financial instrument actually is indexed directly with inflation.The important issue is how the product is structured. From the point of view of the investor, what matters are the returns, safety of principal and liquidity. Currently, a bank deposit has all these features in nominal terms. Government savings have limited liquidity as certificates and PPFs cannot be cashed in at all times. The IIB has to necessarily address all these issues.Now, if the government issues R10,000 crore of G-secs for, say, 10 years, an average inflation rate of even 6% per annum over this period will mean that the principal value gets inflated to something close to R18,000 crore. Add to this the interest payments—which today would be a plain vanilla R6,000 crore—will get converted to approximately R8,000 crore. This will get reflected in higher interest outgo for the government as well as enhanced principal repayments if that is how the deal is structured. The government has to automatically take a hedge back-to-back in interest rate futures (where the securities dealt with are its own) or else the budgetary numbers would go out of hand.In case both the principal and interest payments are covered, it should be a very good option, especially since inflation never goes into the negative zone. The choice of inflation rate is critical here. Often the CPI inflation number is at least 200 bps above the WPI. But there are times when the opposite holds true too. To make it work at the retail end, it has to be benchmarked to the higher index if possible or the CPI if they cannot be alternated.An interesting question that arises is what happens in case inflation comes down or goes into the negative zone. But to cover the contingency, the product has to be structured such that the downside is covered and a floor is maintained all through. This is an issue in developed countries where inflation can turn negative, in which case the nominal return would decline. In India, we have never had to face such a situation.IIBs encounter another challenge in terms of liquidity. This is a problem for all debt market instruments where liquidity is limited. The G-sec market is liquid in just a handful of securities with tenures of 5 or 10 years and at times a couple of other tenures. The corporate debt market is illiquid by all standards. Where would this place IIBs? For those holding these bonds till maturity—like those who hold gold for long tenures, there would be little incentive to enter the secondary market and hence buyers would be limited as even market makers will find it hard to do business. If market makers do not find it attractive on the buy side, then those who want to exit may have a problem. Given that there is limited retail interest in the bond market, IIBs will face this challenge of liquidity.A way out will be for banks to introduce inflation-indexed deposits (IIDs), which will definitely appeal to the deposit holder. But given the higher cost involved, there would be little incentive to do so, especially since even today the borrowers are complaining of high interest rates which cannot be increased proportionately.Therefore, we do run the risk of these bonds not taking off again. One way to make bonds attractive so that investors move away from gold is to provide a tax break on interest to the holder of the bond. This will not be inflation-proof, but still provide an incentive. Gold actually has this advantage because there is no audit trail of sale of gold, which makes it virtually tax-free. Hence, while the idea is commendable, the issuer would probably be only the government. Getting institutions to buy such bonds actually serves no purpose, if the idea is to deter gold savings. At the retail level, IIDs would be preferable to IIBs, but the former will not work for banks. And given the fiscal strains, the government too would have to review its options if the response is good as the fiscal balances would be pressurised.Will this mean another false start?
Inflation-indexed bond (IIB) is the new flavour of the season. Two factors have regenerated interest in a product that has been experimented with twice, but failed. First, it is believed that people are buying gold as a hedge against inflation, which is depleting our forex reserves. The logic goes that by providing alternative instruments for savings, which provide cover for inflation, people will migrate back to the financial sector. Second, the Union Budget for FY14 has declared that the government will introduce such bonds to provide such a cushion for investors and the government is trying to push these ideas forward. Evidently, it is believed that there is a strong case again, even though the concept did not quite click earlier.IIBs were introduced with different variants in the past—one which indexed principal only and the other where interest payments were also cushioned. There is a move to have such issuances of G-secs soon to institutional investors to begin with and later bring it down to the retail level. The working of the concept is quite rudimentary. If a bond has a face value of R100 and a coupon rate of, say, 10%. If inflation rises to 10%, then the bond is valued at R110 and the interest paid is R11. Intuitively, it can be seen that in all such transactions there is a zero-sum game involved and if the investor is gaining, then the borrower is losing as additional money has to be paid. Textbooks always say that inflationary times are good for borrowers because they pay negative real rates while lenders are at a disadvantage. So, to begin with, the government will be forking out more money if the scheme takes off. The private sector borrowers will not be too keen to load a cost which is otherwise notional in nature as it will be considered to be quite unnecessary given that no other financial instrument actually is indexed directly with inflation.The important issue is how the product is structured. From the point of view of the investor, what matters are the returns, safety of principal and liquidity. Currently, a bank deposit has all these features in nominal terms. Government savings have limited liquidity as certificates and PPFs cannot be cashed in at all times. The IIB has to necessarily address all these issues.Now, if the government issues R10,000 crore of G-secs for, say, 10 years, an average inflation rate of even 6% per annum over this period will mean that the principal value gets inflated to something close to R18,000 crore. Add to this the interest payments—which today would be a plain vanilla R6,000 crore—will get converted to approximately R8,000 crore. This will get reflected in higher interest outgo for the government as well as enhanced principal repayments if that is how the deal is structured. The government has to automatically take a hedge back-to-back in interest rate futures (where the securities dealt with are its own) or else the budgetary numbers would go out of hand.In case both the principal and interest payments are covered, it should be a very good option, especially since inflation never goes into the negative zone. The choice of inflation rate is critical here. Often the CPI inflation number is at least 200 bps above the WPI. But there are times when the opposite holds true too. To make it work at the retail end, it has to be benchmarked to the higher index if possible or the CPI if they cannot be alternated.An interesting question that arises is what happens in case inflation comes down or goes into the negative zone. But to cover the contingency, the product has to be structured such that the downside is covered and a floor is maintained all through. This is an issue in developed countries where inflation can turn negative, in which case the nominal return would decline. In India, we have never had to face such a situation.IIBs encounter another challenge in terms of liquidity. This is a problem for all debt market instruments where liquidity is limited. The G-sec market is liquid in just a handful of securities with tenures of 5 or 10 years and at times a couple of other tenures. The corporate debt market is illiquid by all standards. Where would this place IIBs? For those holding these bonds till maturity—like those who hold gold for long tenures, there would be little incentive to enter the secondary market and hence buyers would be limited as even market makers will find it hard to do business. If market makers do not find it attractive on the buy side, then those who want to exit may have a problem. Given that there is limited retail interest in the bond market, IIBs will face this challenge of liquidity.A way out will be for banks to introduce inflation-indexed deposits (IIDs), which will definitely appeal to the deposit holder. But given the higher cost involved, there would be little incentive to do so, especially since even today the borrowers are complaining of high interest rates which cannot be increased proportionately.Therefore, we do run the risk of these bonds not taking off again. One way to make bonds attractive so that investors move away from gold is to provide a tax break on interest to the holder of the bond. This will not be inflation-proof, but still provide an incentive. Gold actually has this advantage because there is no audit trail of sale of gold, which makes it virtually tax-free. Hence, while the idea is commendable, the issuer would probably be only the government. Getting institutions to buy such bonds actually serves no purpose, if the idea is to deter gold savings. At the retail level, IIDs would be preferable to IIBs, but the former will not work for banks. And given the fiscal strains, the government too would have to review its options if the response is good as the fiscal balances would be pressurised.Will this mean another false start?
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