Basics of Inflation-Indexed Bonds-VRK-05Oct2011

Basics of Inflation-Indexed Bonds

Inflation-indexed bonds are bonds issued by the government and their returns are based on inflation. If the inflation rate goes up, the bonds offer higher returns and vice versa. They offer a hedge against inflation risk. They are real safe assets for long-term investors.

Inflation-indexed bonds were first issued by the UK Government in the early 1980s and the US Government issued them in 1997. In the US, they are called as Treasury Inflation Protected Securities or TIPS. In TIPS, the principal amount changes in relation to inflation index. In other countries, like, Canada, New Zealand and South Africa, they are very popular.

International experience suggests that inflation-indexed bond prices have tended to move opposite stock prices indicative negative relationship. As such, these bonds are used by investors as a hedge against equity risk for diversification.

On behalf of the Indian government, Reserve Bank of India issued 5-year capital-indexed bonds (a form of inflation-indexed bonds) in December 1997 for the first time and collected Rs 705 crore from that issue. The inflation adjustment for the bonds was based on wholesale price index or WPI. After that, RBI never issued any further capital-indexed bonds due to lack enthusiastic response from market participants as the bonds offered inflation hedging only for the principal but not for the coupons.

A few days back, RBI Governor, D.Subbarao, said that the central bank was planning to reintroduce inflation-indexed bonds. This is an interesting development for investors when price rise is becoming unbearable.