Prelimsverse: Concept of Inflation-indexed Bonds simplified!

Inflation-linked bonds are designed to help protect investors from the negative impact of inflation by contractually linking the bonds’ principal and interest payments to a nationally recognized inflation measure such as the wholesale price index (WPI).
Inflation-indexed bonds give returns that are more than the rate of inflation, ensuring that price rise does not erode the value of investors’ savings.
For example, if the annual coupon is 8 percent and the principal is Rs 100, the investor will be paid Rs 8 a year. If the inflation index rises 10 per cent, the principal will become Rs 110. The coupon will remain 8 per cent, resulting in an interest payment of Rs 110 x 8 per cent = Rs 8.8.
However, according to the RBI, the new product of Inflation-Indexed Bonds (IIBs) will provide inflation protection to both principal and interest payments.
Inflation component on principal will not be paid with interest but the same would be adjusted in the principal by multiplying principal with index ratio (IR). At the time of redemption, adjusted principal or the face, whichever is higher, would be paid.
Interest rate will be provided protection against inflation by paying fixed coupon rate on the principal adjusted against inflation.

Why will WPI be used for inflation protection? Why has CPI not been considered the same?

1. The consumer price index (CPI) reflects the inflation people face and therefore, globally CPI or Retail Price Index (RPI) is used for inflation targets by the Central Banks as well as for providing inflation protection in IIBs.
2. In India, all India CPI has been released since January 2011 and it will take some time to stabilize. Monetary policy has also been continuing to target WPI for its price stability objective. In view of above, it has been decided to consider WPI for inflation protection in IIBs

What will be the tax treatment of interest payment and capital gains accrual due to inflation?

1. Extant tax provisions will be applicable on interest payment and capital gains on IIBs.
2. There will be no special tax treatment for these bonds.

Whether foreign institutional investors (FIIs) will be allowed to invest in IIBs?

1. IIBs would be Government securities (G-Sec) and the different classes of investors eligible to invest in G-Secs would also be eligible to invest in IIBs.
2. FIIs would be eligible to invest in the forthcoming IIBs but subject to the overall cap for their investment in G-Secs (currently USD 25 billion).

Whether IIBs will be traded in the secondary market?

As IIBs are G-Sec, they can be tradable in the secondary market like other G-Secs. Investors will be able to trade them in NDS-OM, NDS-OM (web-based), OTC market, and stock exchanges.

Whether IIBs will be eligible for short-sale and repo transactions?

IIBs would be a G-Sec and therefore, would be eligible for short-sale and repo transactions.

Whether IIBs will be eligible for statutory liquidity ratio (SLR)?

IIBs would be a G-Sec and issued as part of the approved Government market borrowing programme. Therefore, IIBs would automatically get SLR status.

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