Inflation Indexed Bonds

Introduction

• An inflation-indexed bond (IIB) is a bond issued by the Reserve Bank of India that guarantees a fixed yield regardless of the level of inflation in the economy. 
• Inflation-indexed bonds are designed to provide a hedge and protect investors from macroeconomic risks in a country. 

A brief history about IIB

• In India, during the period 2008-2013, when real interest rates were constantly negative, inflation was one of the primary macroeconomic problems of the country. As a result, households invest heavily in the alternative instrument (gold), necessitating substantial gold imports. 
• The Government of India introduced inflation-indexed bonds (IIB) in 2013 to lessen the attractiveness of gold as an investment and to lower the CAD. 
• The Reserve Bank of India auctioned its first tranche, which was linked to WPI headline inflation, which was then utilized by RBI as the major gauge of inflation. As inflation has moderated significantly since 2014-15, IIB bonds have lost their appeal over time. 
• In April 2014, the RBI changed its monetary policy stance to use the Consumer Price Index (CPI combined) as the primary measure of inflation. 
• If RBI issues new IIB bonds in the near future, they will be based on CPI, which the RBI has recognized as the key measure of inflation for its monetary policy stance in 2014. 

Important Points

• The IIB is specially designed to safeguard an investor’s investment from future uncertainties about the inflation rate. The principal amount is protected in the Inflation Indexed bonds which means an investor will at least get back his whole principal amount. 
• The Inflation Indexed Bonds provide extra interest according to the rate of inflation. In IIBs an investor not only gets an additional rate of interest due to inflation but also gets a fixed rate on the principal amount and can withdraw annually.
• Inflation indexed bonds are currently linked to Wholesale Price Index (WPI) and not CPI. The Wholesale Price Index or WPI is an index that showcases the rise or fall in the price of wholesale products in the basket.