Inflation Indexed Bonds

Transcription

1 Inflation Indexed Bonds Payal Ghose Pursuant to the announcement made in the In the real world, inflation uncertainty creates a Union Budget for to introduce risk for both investors and issuers. The real yield instruments that will protect savings of investors from inflation and incentivize the household sector to save in financial instruments rather than buy gold, the Government of India started the auction of Inflation Indexed Bonds (IIBs) in June This write-up provides an overview of the dynamics behind the issue of this instrument of a fixed-coupon bond differs from its expected yield whenever actual inflation differs from expected inflation. While the nominal yield of a bond can be adjusted to account for expected inflation at the time the bond is issued, the bond's actual real yield varies with actual inflation, which can be quite different from what and discusses its various features. was expected. If actual inflation rises Rationale unexpectedly, the real rate falls; and if inflation declines unexpectedly, the real rate increases. As Generally speaking inflation refers to a rise in the general level of prices of goods and services over a period of time. Inflation erodes the purchasing power of money, as when the general price level rises, each unit of currency buys fewer goods and services. In other words, inflation results in loss of real value. Thus, inflation is the worst fear of investors, especially for those active in the fixed income market. An uptake in inflation results in declining real returns for investors. Uncertainty about the future purchasing power of money discourages investment and saving. As their prices have generally risen in the long run, shifting wealth from financial into real assets such as gold or real estate is believed to preserve purchasing power. However, only an instrument linked to a price index can provide a true hedge against inflation. it is impossible to know with certainty the actual rate of future inflation, inflation risk is intrinsic to nominal bonds and cannot be eliminated. Inflation indexed bonds help in bridging the uncertainty gap and reduce the risk for the investors. With inflation risk generally being a problem only for long-term nominal bonds, the benefits of indexed bonds are largely associated with long-term bonds. With an IIB, the real rate of return is known in advance, and the nominal return varies with the rate of inflation realized over the life of the bond. Hence, neither the purchaser nor the issuer faces a risk that an unanticipated increase or decrease in inflation will erode or boost the purchasing power of the bond's payments. Inflation Indexed Bonds An inflation-indexed or inflation-linked bond is an instrument designed to protect the Ms. Payal Ghose is Deputy Manager, Economic Research and Surveillance Department, CCIL September 2013 CCIL Monthly Newsletter 7

2 CCIL Monthly Newsletter September 2013 purchasing power of an investor's savings by indexing interest and principal payments to a chosen price index. As prices go up, so, too, do the payments from an indexed bond, thereby protecting the holders of indexed bonds from inflation. The real rate of return on an IIB is known in advance, and the nominal return varies with the rate of inflation realized over the life of the bond. Hence, neither the purchaser nor the issuer faces a risk that an unanticipated increase or decrease in inflation will erode or boost the purchasing power of the bond's payments. The inflation component on principal is not paid with interest but the same is adjusted in the principal by multiplying principal with index ratio (IR). The IR is calculated by dividing the reference price index on the settlement date with Year Inflation Index (II) Index Ratio IRti=(IIti /IIt0) Nominal Value of Principal Conventional Bond the reference price index on the issue date. At the time of redemption, adjusted principal or the face value, whichever is higher, is paid. The interest component is provided protection against inflation by paying a fixed coupon rate on the principal adjusted against inflation. Schedule of Payments Real Value of Principal Nominal Interest Payment Example of Payments on Conventional and Indexed bonds Let us consider a 10-year conventional bond and a 10-year IIB. Each bond is purchased at its face value of `100 and is assumed to provide annual coupon payments. Each coupon payment on the conventional bond is the coupon rate stated on the bond times the principal. Each coupon payment on the IIB is the coupon rate times the indexed principal. The indexed principal is simply the initial face value of `100 scaled up through time at the rate of inflation. Let us assume that the coupon rate on the indexed bond is 1.44% and that on the conventional bond is 7.16%. A schedule of nominal and real values of payments on the bonds is given below. Real Value of Interest Payment Nominal Value of Principal Inflation Indexed Bond Real Value of Principal Nominal Interest Payment Real Value of Interest Payment The real values give the purchasing power of the nominal payments. As the schedule of payments shows, the nominal value of the conventional bond's principal stays fixed. However, the real value is eroding through time because of inflation. When received at maturity, the `100 8

3 principal can purchase goods worth `96.83 only as against the `100 worth of goods that could be purchased at the onset. The payment schedule also shows how the fixed nominal payment of `7.16 per year on the nominal bond has a smaller real value over time because of inflation. On the other hand, for the IIB, the real values of the principal and interest payments are preserved for the life of the bond. The nominal principal gets scaled up year by year according to inflation. As the principal gets scaled up, so, too, does the nominal coupon payment to preserve the real return of 1.44% in the example. The IIB pays less interest than the nominal bond each year, but that is offset by its larger payment of principal at maturity. Break-even Inflation An important concept linking the two bond strategies together is the so called breakeven inflation rate (BEIR). The breakeven inflation level makes an investor indifferent, whether to invest in conventional bonds or inflation linked bonds. The spread between the nominal and the real yield, equates the two strategies. Breakeven rates are often compared with market forecasts of inflation, providing a measure of which bond to buy. If an investor expects the forward inflation rate, based on the BEIR to be too low, the IIB is a buy. The BEIR is of particular interest to the central banks as it is a daily source of information on private sector inflation expectations and it is available across several maturities. Benefits of Issuing IIBs IIBs are inherently beneficial to both investors and issuers. These benefits could be broadly categorized into business proposition and usefulness for policy making. The benefits of IIBs accruing to various stake holders are discussed below: A) For the Investors: Insulation from Inflation: On the demand front, investors may have appetite for such bonds because of their inherent property to insulate against inflation risk. The yield asked by investors on nominal fixed rate bonds factors in their average inflationary expectations over the maturity period and uncertainty premium besides real yield. Thus, investors are exposed to inflation risk especially, as the projections of average inflation over the long term are difficult to be robust and tend to deviate from actual inflation. IIBs give the investors long-term assets with a fixed long-term real yield insulating them against inflation as their real yields are indexed to actual inflation. Risk Diversification: From a standard portfolio diversification point of view, IIBs provide an avenue for the investors to diversify their asset portfolios especially when inflation is uncertain. Further, as IIBs offer assured real yield over the maturity, they enable market participants such as pension funds and insurance companies to offer indexed annuity scheme providing inflation protection to their clients. B) For the Issuer: Cost Saving for Issuer: From cost saving perspective, issuance of IIBs is a good September 2013 CCIL Monthly Newsletter 9

4 CCIL Monthly Newsletter September 2013 business proposition for the issuers such as Sovereigns. The rationale is that, if investors are willing to pay a premium for protection against inflation, then this premium will be reflected in a lower yield paid by the government on debt instruments that provide such protection. Assuming actual inflation equals expected inflation, the Government will be paying lower nominal yield on IIBs to the extent of uncertainty premium. Credibility of the monetary policy for anchoring inflation may also help in reducing the inflation risk premium borne by the rest of the (nominal) debt thereby leading to further savings. However, the cost savings on issuance of IIBs need to be judged over the life of the security and not on yearly basis. The government is able to gain because of its ability to influence future inflation through its policies as well as because it has better information about the future course of inflation. Constant Real yield: Another benefit to the Government is that the real yield on IIBs would remain constant over the period despite changes in the inflation rate, while real yield on the nominal fixed rate bonds would vary as per the changes in the inflation rate. In the case of nominal fixed rate bonds, whose coupon rate is contracted based on extant inflationary expectations, servicing interest payments becomes very costly during low inflation periods. Anchored Revenue: Interest payouts on IIBs are indexed to inflation as is the Government's revenue. Thus, nominal interest payouts anchored to the revenues of the Government, leave no mismatch on account of inflation. The government will be able to attain a more predictable budgetary position because of matching of real cash flows. A reduction in volatility helps promote the regularity and predictability of the issuance calendar, which increases the liquidity of outstanding securities and helps to foster demand at auctions. Gauging Inflation Expectations: IIBs help in gauging the market's inflation expectations and understanding the forces that influence inflation expectations, which are pivotal for policy purposes. Minute-by-minute data in advanced markets on inflation compensation from financial markets provides a gauge of the effects of monetary policy actions and macroeconomic data releases on inflation expectations. Improved Fiscal Policy: Increasing issuance of IIBs by the Government also reflects its commitment towards inflation and in the process facilitates anchoring of the inflationary expectations. Aid to Develop Capital Markets: IIBs have proved to be the only method by which countries facing hyper-inflation have mobilized capital and prevented collapse of long-term capital markets. It also helps in improving the quality of private savings, particularly voluntary savings while lengthening the maturity of debt. As the government gets access to a broader investor base its overall funding costs can be reduced. 10

5 C) For Societal welfare: Market Completeness: Yields on the government bonds provide the benchmark risk-free rates for the market. Issuance of IIBs fills a void in the market by providing the market with a risk-free instrument in terms of both credit risk as well as purchasing power risk. Investors will be able to match their long-term liabilities that vary with the price level against these bonds. Thus the government will be able to achieve greater degree of market completeness which may further help in cost savings for it. Incentives for Saving: Conventional financial instruments often fail to give real returns during inflationary periods. As a result, investors move from financial assets to real assets further stoking the inflationary spiral. IIBs are the best way of boosting savings in the economy as a whole without stoking inflation. Indexation also encourages investors to invest in the domestic economy rather than acquiring foreign assets to beat the domestic inflation. Distributional Benefits: Unanticipated inflation implies unintended transfers of wealth from lenders to borrowers. Economists have argued that by indexing its liabilities the government can transfer back to the public part of the inflation tax for which it is responsible. Disadvantages of Issuing IIBs May turn out costly for issuer: One of the benefits i.e. cost saving for the Government borrowings may not accrue under certain circumstances and on the contrary, costs may turn out to be higher. For instance, if the expost (actual) inflation turned out to be higher than ex-ante (expected) inflation, the cost of IIBs would be higher than that of nominal fixed rate bonds. Furthermore, at the time of issuance, the liquidity premium asked by investors on IIBs (as it may be less liquid initially due to lack of a critical mass) may turn out to be higher than the cost savings accruing on account of removing the uncertainty premium. Incorrect Estimate of Inflation Expectations: Subtracting the real yields on IIBs from the nominal yields on conventional bonds is regarded as an instantaneous measure of expected inflation. However, this argument is regarded as flawed due to the prevailing asymmetry of information. Any sudden or temporary movements in the yields can present a distorted picture as the investors do not have access to the same information like the government or central bank and they cannot fully assess the policy actions to counter inflation. Moreover, the presence of liquidity premium for indexed bonds can cause the yield gap to underestimate inflation expectations. The indexation lags also distort the information content of the yield spreads. Higher Indexation: On the policy front, large issuances of IIBs may lead to a higher level of indexation of the economy and in turn, may reduce the effectiveness of the public policy in containing inflationary expectations. However, studies have not found the link September 2013 CCIL Monthly Newsletter 11

6 CCIL Monthly Newsletter September 2013 between inflation and indexing inevitable and use of appropriate policies could prevent the indexing from leading to higher inflation (Fisher, 1983). Destabilizing Effect: Unlike demand-pull inflation, the Government's revenue cannot be anchored to inflation emanating from supply side shocks as prices are not driven by income. Therefore, larger issuance of IIBs may destabilize the Government finances during a cost-push inflation period. Price Index The selection of the reference price index plays a key role in the success of IIBs as different investors have different objectives due to which if the chosen index does not match the investor's goal well, the IIBs do not offer ideal protection. The chosen index should be widely trusted to help in standardization and should be frequently published in order to minimize the effect of the inflation lag. A common index also helps to widen the participant base. Another problem for investors is seasonality in the index that arises because some components of the index are more affected by inflation during the year than others, causing changes in intra year price levels. Indexation Lag In order to quote an inflation adjusted market price for IIBs, a daily reference number is calculated. As inflation is not known ex ante, IIBs are generally subject to an indexation lag i.e. bond payments are linked to a lagged value of a price index. The lag is technically inevitable because of the delays in compilation of data and the publication of the index. For example, the lag for IIBs in the United Kingdom was eight months prior to 2005, while for Canadian and U.S. indexed bonds, the lag is three months. The problem of the inflation lag is mainly prevalent for IIBs with a relatively short maturity where the inflation lag accounts for a considerable time of the life of the bond. Global experience The State of Massachusetts issued one of the first documented IIBs, whose principal and interest were linked to the price of a basket of goods in Although economists have traditionally argued in favor of these bonds, their issuance actually caught attention of governments after World War II. More and more countries are now issuing IIBs and the global market for IIBs has gone through a rapid growth phase in the last two decades. The US market for Treasury Inflation- Indexed Securities (TIIS, also referred to as Treasury Inflation-Protected Securities, or TIPS) is now the largest inflation bond market. IIB issuing countries can be broadly classified into the following three groups: Sovereigns trying to find acceptability of investors so to be able to raise capital in a high and volatile inflationary economy such as Israel (in mid-1950s), Chile (in 1956), Brazil (in 1964), Colombia (in 1967) and Argentina (in 1973). Sovereigns trying to reduce the borrowing costs, given the relatively high inflation expectations such as the United Kingdom (in 1981), Australia (in 1985), Sweden (in 1994) and New Zealand (in 1995). 12

7 Sovereigns trying to achieve market completeness and offering IIBs as a hedge against inflation such as Canada (in 1991), the United States (in 1997), France (in 1998), Greece and Italy (in 2003), Japan (in 2004) and Germany (in 2006). As can be seen IIBs still account for a minor, although in most of the cases, a rising share in government debt. Thus, IIBs perform a role complementary to nominal debt, which remains dominant in every country. Inflation Indexed Bond Issuance by Select Countries Year Outstanding Inflation-Linked Debt Issued by the Central Government (In USD Billion) Argentina Australia Brazil Canada Germany Israel United Kingdom United States NA Year Share of IIBs in Total Government Debt (In Percent) Argentina Australia Brazil Canada Germany Israel United Kingdom United States NA Source: BIS September 2013 CCIL Monthly Newsletter 13

8 Treasury Inflation-Protected Securities (TIPS) Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. Even though the United States was a late entrant, the TIPS market has witnessed tremendous growth and currently is the largest market globally for IIBs. The U.S. Treasury has been issuing TIPS since early 1997 in an attempt to broaden the investor base for US government debt and to reduce the Treasury's long-term debt servicing costs with the issuance of a real return bond. The principal is adjusted to the Consumer Price Index (CPI), the commonly used measure of inflation. When the CPI rises, the principal 2012 Israel Canada Australia Snapshot of Outstanding Inflation-Linked Securities United Kingdom Germany Brazil United States Year 2008 Israel Germany Canada Australia Brazil United Kingdom United States Amount Outstanding (USD Billion) 2004 Israel Germany Canada Brazil Australia United States United Kingdom Australia Brazil Canada Germany Israel United Kingdom United States Outstanding Debt - United States 16 CCIL Monthly Newsletter September 2013 Amount Outstanding (USD Billion) TIPS Total Public Debt Outstanding % Share of TIPS Aug %ShareofTIPS 14

9 adjusts upward. If the index falls, the principal adjusts downwards. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflationadjusted principal, thus protecting the holder against the official inflation rate (as asserted by the CPI). TIPS are currently offered in 5-year, 10-year and 30-year maturities. On an average, TIPS constitute about 8% of the total public debt. When a TIPS matures, the investor is paid the inflation-adjusted principal or original principal, whichever is greater. Since a TIPS investor cannot receive less than the original principal, the investor's original principal amount is protected against deflation as well. TIPS pay interest semiannually at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation. Auction Frequency The 5-year TIPS is auctioned as an original issue in April. The 5-year TIPS is auctioned as a reopening in August and December. The 10-year TIPS is auctioned as an original issue in January and July. The 10-year TIPS is auctioned as a reopening in March, May, September, and November. The 30-year TIPS is auctioned as an original issue in February. The 30-year TIPS is auctioned as a reopening in June and October. All TIPS accrue interest from the 15th of the month and are issued on the last business day of the month. For original issue TIPS, accrued interest is payable by the investor from the 15th until the issue date. For reopened TIPS, accrued interest is payable from the dated date on the announcement until the issue date of the reopening. All reopened securities have the same maturity date, coupon interest rate, and interest payment dates as the original security but have a different issue date and usually a different price. Bidding: Auction bids for Treasury securities may be submitted as noncompetitive or competitive. With a noncompetitive bid, a bidder agrees to accept the yield determined at auction. With a competitive bid, a bidder specifies the yield that they are willing to accept for a particular security. This bid may be fully awarded if the yield specified is less than the yield set by the auction, partially awarded if the yield specified is equal to the high yield, or not awarded if the yield specified is higher than the yield set at the auction. Adjusting TIPS Principal: Each month, the U.S. Treasury publishes daily index ratios that are used to adjust the principal of TIPS. The index ratios are based on the latest changes to the Bureau of Labor Statistics Consumer Price Index for All Urban Consumers (CPI-U): U. S. City Average, by expenditure category and commodity and service group (not seasonally September 2013 CCIL Monthly Newsletter 15

10 adjusted). The principal of a TIPS increases with inflation and decreases with deflation. Tax Considerations: Interest on TIPS is exempt from state and local taxes but is subject to federal tax. TIPS investors pay federal income tax on interest payments in the year they are received and on growth in principal in the year that it occurs. TIPS issuance at a glance: Original Issue Yield: The yield determined at auction. Minimum purchase: $100 Maximum purchase: Non-competitive: $5 million Competitive: 35% of offering amount Investment Increment: Multiples of $100 Issue Method: Electronic Source: BIS & Treasury Direct The Indian Economy Preservation of capital becomes the key consideration for investors in an uncertain economic environment. The Indian economy is currently going through a turbulent phase with slowing growth, high inflation, declining savings, a ballooning external sector deficit and high volatility in the exchange rate. The uncertainty in the financial markets has led to a flight to the relative safety of physical assets like gold and real estate further driving up their prices. The liquidity glut resulting from the unprecedented measures of central banks in the advanced economies in response to the financial crisis and the pursuit of returns has resulted in huge capital inflows into emerging economies like India and fuelled inflation there. This liquidity has also sustained the global increase in commodity prices further adding to the inflationary situation in emerging markets. Inflation in India as measured by the WPI and CPI has persisted due to factors such as administered price revisions in fuel products, CCIL Monthly Newsletter September 2013 Savings (` Thousand Crore) Household Sector Savings Financial Savings (FS) Physical Savings (PS) Change in FS Change in PS Change in Savings (%) Source: RBI 16

11 sustained pressure on food prices and passthrough from global commodity prices and exchange rate changes. Amid high inflation, the problem of the falling savings rate due to low or negative real returns has emerged as an important contributor to growing macro-economic imbalances in the Indian economy. The economic environment is becoming very complex in India for yielding high inflationadjusted returns. For example, while saw an average CPI of 10.21% and average WPI of 7.36%, the Sensex has given an annual return of 8.23% during the period; gold has given a return of 5.96%, returns from bank deposits have been in the range of % and the average yield on 10-year benchmark bonds has been 8.15%. On the other hand, residential real estate has given an annual return of 19.40%. However, these trends change if the data over the past five years is considered thereby reflecting the complexity of the situation. The latest available data on savings reflects the Indian households' preference for valuables, especially gold, during the recent period due to the relatively low real interest rates on deposits and financial instruments such as small savings and the uncertain stock market conditions. As most of the gold consumed in India is imported, this trend has contributed significantly to the widening of the current account deficit (CAD). Recognizing the implications of gold imports for external sector stability, the Reserve Bank of India (RBI) set up a working group to study issues relating to gold imports. The working group found that gold was being increasingly considered as an investment that appreciates over years and provides a hedge against inflation. Gold was also considered as a medium that can be pledged easily during difficult times for securing financial accommodation. It therefore suggested the introduction of savings schemes and instruments like IIBs that could provide real returns with flexible liquidity options. Another RBI working group on enhancing liquidity in the government securities and interest rate derivatives markets had previously found a need to tap the private savings of the country through special government bonds aimed at individual investors. As a beginning it had advised the government to consider issuing inflationindexed bonds specifically for retail/individual investors as inflation affects them significantly. In the light of these recommendations and for incentivizing the household sector to save in financial instruments rather than buy gold, in the Union Budget for , the government proposed to introduce instruments that will protect savings from inflation, especially the savings of the poor and middle classes through Inflation Indexed Bonds or Inflation Indexed National Security Certificates. Subsequently, RBI announced the scheme for Inflation Indexed Bonds (IIBs) on May 15, Past Experience RBI had issued one variant of IIBs - the 6% Capital Index Bond 2002, for ` crore on December 29, 1997, wherein only principal repayments at the time of redemption were indexed to inflation. The inflation adjustment for the repayment of the principal was based on the monthly average of the WPI as worked out by the RBI on the basis of the WPI for all September 2013 CCIL Monthly Newsletter 17

12 commodities issued weekly by the Ministry of Industry, Government of India. Subsequent to that issuance, no further CIBs were issued mainly due to lack of an enthusiastic response of market participants for the instrument, both in primary and secondary markets. The reasons cited for the lackluster response were that it only offered inflation hedging for the principal, while the coupons of the bond were left unprotected commodities. A technical paper released in December 2010 set out the structure of IIBs including method of indexation (principal or interest), inflation index lag, issuance method, and methodology to compute settlement price. After the announcement made in the Union Budget for , RBI announced the following scheme for launching IIBs on May 15, Details for first series of IIBs issued by RBI CCIL Monthly Newsletter September 2013 The IIBs will have a fixed real coupon rate and a nominal principal value that is adjusted against inflation. Periodic coupon payments will be paid on adjusted principal. At maturity, the adjusted principal or the face value, whichever is higher, will be paid. Index ratio (IR) will be computed by dividing reference index for the settlement date by reference index for issue date (i.e., IR set date = Ref. Inflation Index Set Date/Ref Inflation Index Issue Date). Final WPI will be used for providing inflation protection in this product. Final WPI with four months lag will be used. These bonds will be issued by auction method. against inflation and the complexities involved in pricing of the instrument. Based on this experience and the feedback from market participants, a new version of IIBs was designed in 2004 with an inherent protection from inflation to both interest payments and principal repayments and linking them to WPI for all Non-competitive portion will be increased from extant 5% to up to 20% of the notified amount in order to encourage participation of retail and other eligible investors. Issuance would target various points of the maturity curve in order to have benchmarks. To begin with, these bonds will be issued for tenor of 10 years. Each tranche of IIBs will be for `1,000-2,000 crore and total issuance would be for about `12,000-15,000 crore in The first such tranche will be issued on June 4, 2013 and the same would be issued regularly through auctions on the last Tuesday of each subsequent month during Although the IIBs have been introduced primarily for protecting savings of retail investors from inflation and incentivizing the household sector to save in financial instruments rather than buying gold, RBI has first decided to issue comparable instruments through auctions to the institutional investors 18

13 such as pension funds, insurance companies and mutual funds etc. to facilitate appropriate price discovery and market development. This will also create demand for IIBs and help in making them tradable in the secondary market. RBI has therefore decided to issue the initial series for all categories of investors including institutional investors and, later, another series, exclusively for retail investors. The first series of IIBs would be issued in the first half of To target greater retail participation in this series also, the non-competitive segment for retail and midsegment investors has been enhanced to 20% from the present level of 5% applicable to auction of usual gilts. The first series of the IIBs will help in determining the coupon rate for the bonds through auction and help in benchmarking IIBs. The second series of IIBs exclusively for retail investors will be issued in second half of the financial year around October. RBI will announce the terms of issuance of IIBs for retail investors in due course. Globally, the CPI is widely used index for adjusting the cash flows for IIBs as it is supposed to represent level of inflation that the public at large face. However, IIBs will be indexed to the WPI in India as the all India CPI being released since January 2011 will take some time in stabilizing. In India, monetary policy also targets WPI for its price stability objective. In case of IIBs final monthly WPI will be used as reference WPI for 1st day of the calendar month. The reference WPI for intermittent days, i.e. dates between 1st days of the two consecutive months will be computed through interpolation. For interpolation, two months final WPI should be available throughout the month. As final WPI is currently available with a lag of about two and half months (e.g. final WPI February 2013 will be released in mid-may 2013), two months final WPI could be available only with a lag of four months. In view of above, the four months lag has been chosen for final WPI to be considered as reference WPI for 1st day of the calendar month. For example, December 2012 final WPI will be taken as reference WPI for 1st of May 2013 and January 2013 final WPI will be taken as reference WPI for 1st of June In case of revision in the base year for WPI series, base splicing method would be used to construct a consistent series for indexation. September 2013 CCIL Monthly Newsletter 19

14 Benefits of IIBs - Indian scenario CCIL Monthly Newsletter September 2013 Diversification: IIBs will give Indian investors a low-risk option for protecting their savings from inflation. Inflation erodes the purchasing power of money. The existing debt products such as fixed deposits or regular bonds provide returns that are not protected against inflation. If a bank FD pays an interest rate of 9% per annum and inflation averages 9.5% that year, the investor loses money in real terms. In this case investing in an IIB is a better option as the principal investment is adjusted to the inflation so that the investor earns a higher interest. Smoother implementation of monetary policy: One of the challenges that RBI faces in managing monetary policy is that it has to gauge inflation expectations from the yield curve as normal bond yields have embedded inflation expectations. With instruments like IIBs which reflect inflation expectations explicitly, it will be easier for the central bank to gauge the market's expectations for inflation. Reduction of CAD: The real rate of return on an investment is what investors get from it (nominal return) minus the inflation rate. Over the past few years, the high inflation in India resulted in negative real returns on financial investments such as bank FDs. This led retail investors to flock to riskier assets such as gold and real estate. However, the increasing demand for gold, most of which is imported, has severely hampered the country's external balance. The launch of IIBs will provide a major respite on the CAD front if they are able to wean away investors from gold. Tax benefits: In comparison with general bonds, the absolute coupon cash flow on IIBs is lower but the principal repayment is higher as it is adjusted for cumulative inflation. While investors may avoid an instrument which offers lower coupon income, it actually helps them to gain from the lower tax deduction on the interest earned on IIBs. Hence, these bonds are suited best for those investors who are looking for inflation protection over a longer time horizon and those who are not in great need of a regular cash flow. For instance, a 30% tax on 8% interest earned on a general bond will be 2.4%. This is almost six times compared with the 0.43% tax an investor has to pay on interest earned at a real coupon rate of 1.44% and would change marginally due to inflation-adjusted coupon. Further, investors benefit from indexation benefits of taxation on capital gains from such bonds. Long-term capital gains currently attract 20% tax with indexation benefit. Consistent high inflation has pushed up the capital gains index, which will ensure that investors will pay marginal or no tax on capital gains. For IIBs, the pre-tax and post-tax returns are almost the same. 20

15 Some disadvantages of IIBs - Indian scenario Funding of the spread: In the first tranche auctioned by RBI the spread was fixed at 1.44% over and above the WPI numbers of January Over time the return from the bonds is expected to increase as a deflationary condition is unlikely in a developing economy like India. As the spread increases with inflation, it will result in more cash outflows for the government. RBI expects to auction IIBs worth `12,000-15,000 crore in the current fiscal. These bonds will be issued for 10 years with a spread of 1.44% over WPI, revised at periodic intervals. The coupon on a conventional 10- year benchmark bond at the time of its issue takes into consideration the inflation expectations at that point 12 of time for the next 10 years 11 and thereafter remains 10 fixed throughout the life of 9 the bond. However, in case 8 of IIBs the coupon 7 outflows will increase with 6 inflation. In other words, 5 the government will have 4 to fund the spread adding to the fiscal deficit in the future. Therefore though these bonds may provide some respite from the burgeoning CAD by curtailing gold investments by the public, they will add to the government's fiscal deficit, particularly if inflation spikes due to temporary shocks. (%) Linked to WPI, not CPI: In their current form IIBs will provide retail investors only a partial hedge against inflation and not a New CPI perfect one as these are linked to the wholesale price index (WPI) and not to the consumer price index (CPI). Even RBI acknowledges that it is the CPI that reflects the inflation people face at large. Over the past few years India has been facing a wide divergence between the WPI and CPI. For example, CPI inflation in April was 9.39% which was almost double the 4.77% inflation as per the WPI. The gap has widened as prices at the wholesale level have been declining faster than that those at the retail level. If this trend continues, the ability of the current series of bonds to provide a complete hedge against inflation weakens further from the point of view of a retail investor. New CPI vs WPI WPI Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Instability in index: The WPI calculation is flawed and often subject to major revisions between initial and final reported figures. Calculation will also change if the base year for estimation is change. Currently, India will be the only major country that uses a WPI instead of a CPI for IIBs. Ease of operation: Participation of retail investors is negligible in the Indian debt September 2013 CCIL Monthly Newsletter 21

16 CCIL Monthly Newsletter September 2013 market because of the various restrictions on direct participation. Buying gilts is also prohibitive for retail investors because of the minimum lot size and also the commission charged by the dealers through whom they have to route their trades. Thus, these investors prefer to park their money in physical assets like gold or bank deposits and the equity market where they have direct entry. As such investors are the target group for the new IIBs, the need of the hour is to enable more risk-averse small investors to subscribe to IIBs so that their demand for gold is lowered, curtailing imports thereby reducing the CAD. The government and regulators must ensure the attractiveness of these bonds for retail investors by making the structure simple and easy to understand. It is also imperative for regulators to provide better incentives to distributors of financial products which will help in improved participation. Illiquidity: The targeted investor groups for IIBs are retail investors and buy-and-hold institutional investors such as insurance companies, pension funds, etc. This may result in illiquidity of the bonds in the secondary market thus restricting a flexible exit option. Liquidity issues can be addressed by measures to promote secondary market activity by creating large benchmark issues through reissues, allowing IIBs as collateral for repo, or designating specialized marketmakers for these bonds. Tax aspect: IIBs currently do not offer special tax concessions. So, both the interest received and the capital gains on the bonds will be taxable thereby reducing the real returns. It is only at maturity that a retail investor will be able to realize the full advantage of the inflation protection offered by the IIBs. On maturity, the adjusted principal amount is repaid which takes into account cumulative inflation for the entire tenor. This will be higher than the nominal principal repaid in a normal bond or bank fixed deposit. However, the regular interest received is much lower than that for bank deposits or other debt, because they reflect real rates. While capital gains will be taxable, the indexation benefit available on long term capital gains should lessen the tax burden significantly. IIBs can be traded in the secondary market, but the profit on sale will attract capital gains tax. On the other hand, investments like bank fixed deposits are safe alternatives for retail participants. Let us assume that the rate offered on a deposit of more than 5 years is 9.25% p.a. and the WPI is 4.86%. On a post-tax basis, the real return on these deposits considering WPI-based inflation works out to 3.95% for investors in the 10% slab, 3.51% for those in the 20% slab, and 3.07% for those in the 30% slab. This indicates that an IIB which offers a real rate of 3% or less may be worthwhile only for investors in the highest tax slab. Others could consider investing in comparably safe bank deposits for better post-tax real returns. 22

17 Primary Market The first auction for IIBs maturing in 2023 was conducted on June 4, 2013 using uniform price method for `1,000 crore. The cut-off yield was set at 1.44%. The security was subsequently re-issued twice on June 25, 2013 and August 27, 2013 for `1,000 crore each while RBI rejected all the bids in the auction held on July 29, 2013 in order to limit the impact of its liquidity tightening actions. The IIBs are being issued within the planned Government market borrowing and RBI plans to issue between FY14. `12,000-15,000 crore in The strong BCR of 4.68 in the first auction reflects the strong initial interest in the instrument. The BCR may also have been high because of the relatively small size of the issue. However, interest was negligible in the noncompetitive segment despite a 20% reservation. The uncertainty prevailing in the market due to the impact of the various liquidity tightening recently undertaken by the RBI can be seen in the declining appetite for the bonds in the subsequent auctions the last of which even saw a 53% devolvement on the Primary Dealers. Date of Auction Auction Details of 1.44% Inflation Index Government Security, 2023 Type of Auction Notified Amount (` Crore) Competitive Bids Received No. Competitive Bids Received Amount (` Crore) Competitive Bids Accepted No. Competitive Bids Accepted Amount (` Crore) Bid to Cover Ratio Non Competitive Bids Received and Accepted No. Non Competitive Bids Received and Accepted Amount (` Crore) 4-Jun-13 Issue 1, , Jun-13 Re-Issue 1, , Jul-13 Re-Issue 1, , Aug-13 Re-Issue 1, , Date of Auction Type of Auction Source: RBI, CCIL Notified Amount (` Crore) Coupon Rate (%) Cut-off Yield (%) Cut-off Price Devolvement on Primary Dealers (` Crore) Secondary Market Base Index Value Calculated Index Value for Re-issue Calculated Index Ratio for Re-issue 4-Jun-13 Issue 1, Jun-13 Re-Issue 1, Jul-13 Re-Issue 1, Aug-13 Re-Issue 1, Trading activity declined in July after a good start, before picking up again in August. Though trading in the secondary market has been volatile, it is still too early to establish any patterns as it is a new product. September 2013 CCIL Monthly Newsletter 23

18 Month Trades Value (` Crore) Secondary Market Details Average Trades Average Value (` Crore) Weighted Average Yield Monthly Turnover Ratio % Share in Total G-Sec Trading Jun Jul Aug CCIL Monthly Newsletter September 2013 Source: CCIL IIBs were expected to get a good response from insurance companies, provident funds and retail investors etc. However, based on the current data there has been lackluster participation in the CSGL segment. Most of the CSGL activity has been on the buying side. Overall, Mutual Funds followed by Nationalized Banks have been most active on the buying side while Foreign Banks followed by Primary Dealers have been most active on the selling side. Corporate IIBs Globally sovereigns have been the major issuers of IIBs, although IIBs have also been issued by utility providers, real-estate companies and retailers. In the U.K. entities subject to administered prices such as the King's College Hospital have also issued inflation-linked debt. For the issuers, such instruments are a form of variable-rate loans, and can allow them to benefit from an expected reduction in the inflation rate while also expanding the range of their funding options. In India, Larsen & Toubro ( L&T) became the first domestic company to issue such debt before the IIB issued by the RBI on behalf of the government. In case of these debentures, L&T will adjust the principal with respect to the average WPI over a trailing 12-month period, with a lag of 4 months, while the coupon will be fixed at 1.65% over the WPI. The `100 crore issue was rated as AAA/Stable by rating agency CRISIL. Conclusion The consumer price index (CPI) is globally considered to be a better indicator of the cost of living. The lackluster interest of medium and small investors in the current series of IIBs based on the WPI reflects their perception of the inability of the bonds to provide a complete hedge against inflation. The divergence between the WPI and the CPI also compounds this problem. Indian investors/households preferring investments that can offer protection against CPI inflation have thus kept way from these bonds. This fact has also been recognized by the RBI, and in his inaugural statement, RBI Governor, Dr. Raghuram Rajan, announced that Inflation Indexed Savings Certificates linked to the CPI New Index will be issued to retail investors by end-november Active participation of retail investors will also require simplification of the rules for their entry into the market. Only after addressing such issues can the market pick up and serve its original purpose of providing individuals with alternative avenues to investing in gold. 24

19 References: Various reports and notifications of the Reserve Bank of India. Various notifications by FIMMDA. Various reports and statistics of the Bank for International Settlements. The Rationale and Design of Inflation- Indexed Bonds by Robert Price, IMF Working Paper WP/97/12. Inflation-linked Bonds from a Central Bank Perspective by Juan Angel Garcia, and Adrian van Rixtel, ECB Occasional Paper Series No 62 / June The Case for TIPS: An Examination of the Costs and Benefits by William C. Dudley, Jennifer Roush, and Michelle Steinberg Ezer, FRBNY Economic Policy Review/July ANNEXURE 1 Additional FAQs on Inflation Indexed Bonds (Accounting Norms) - Reserve Bank of India 1. How will the daily changes in the inflation adjusted principal be accounted for, regarding MTM Interest Book Value book value of the security should continue to be reduced to the extent of the amount amortised during the relevant accounting period. In the case of IIBs, face value will mean the inflation adjusted principal. Ans: The valuation criteria as specified for HTM, AFS and HFT would apply. Valuation (para nos. given are from our MC on investments) 3.1 Held to Maturity i) Investments classified under HTM need not be marked to market and will be carried at acquisition cost, unless it is more than the face value, in which case the premium should be amortised over the period remaining to maturity. The banks should reflect the amortised amount in 'Schedule 13 - Interest Earned: Item II - Income on Investments', as a deduction. However, the deduction need not be disclosed separately. The 3.2 Available for Sale The individual scrips in the Available for Sale category will be marked to market at quarterly or at more frequent intervals. Domestic Securities under this category shall be valued scrip-wise and depreciation / appreciation shall be aggregated for each classification referred to in item 2(i) above and foreign investments under this category shall be valued scrip-wise and depreciation / appreciation shall be aggregated for five classifications (viz. Government securities (including local authorities), Shares, Debentures & Bonds, Subsidiaries and / or joint ventures abroad and Other investments (to be specified)). Further, the investment in a particular classification, both in domestic and foreign September 2013 CCIL Monthly Newsletter 25