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Inflation can silently eat away at returns, even on seemingly safe investments like bonds. But what if the bonds themselves could keep pace with inflation? Enter capital-indexed bonds (CIBs) and inflation-indexed bonds (IIBs).
First rolled out by the RBI (Reserve Bank of India) in 1997, these instruments can safeguard your principal and interest payments from inflation. India introduced these bonds as an appealing factor to address investors’ concerns about battling inflation and hedge risks.
That said, today’s article will dive deep into the concept of capital-indexed bonds, their pros and cons, and how they differ from IIBs.
Understanding index-linked bonds
An index-linked bond is a fixed-income investment vehicle in which the interest paid out is price index-linked, where the given index is often the CPI or consumer price index. This feature protects investors from changes in the underlying index. The bondholder is guaranteed a specific real rate of return via adjustments to the bond’s cash flows.
As a result, investors remain safe from fluctuations in the index that is linked to it, enabling them to prevent negative returns. Interest payments, also known as coupon payments, are distributed semiannually for these bonds, which typically have a fixed rate.
Given their existing connection to an inflation index, like the Retail Price Index (RPI) or the CPI, these coupon payments have already been inflation-adjusted.
What are capital-indexed bonds (CIB)?
The term “capital-indexed bonds” refers to index-linked bonds that are particularly inflation index-linked. A specific interest rate is applied to the bond’s adjusted face value.
As a result, the principal amount and the full coupon payment are paid to the bondholders at maturity, with adjustments made based on the inflation index.
Capital-indexed bonds example
A normal bond loses value due to inflation. Capital-indexed bonds, on the other hand, hedge inflation. A capital-indexed bond pays interest and principal based on inflation. A capital- indexed bond guarantees to increase your principal at a specific rate.
For example, a ₹10,000 bond with 10% interest and an 8% assumed inflation rate pays ₹1,000 interest and you receive ₹10,800 (inflation-adjusted principal) after one year.
History of capital-indexed bonds issued by the government
The government issued the first capital-indexed bonds in 1997. However, this system left the coupon payments vulnerable to price increases. Therefore, back then, the government was obliged to remove this instrument due to the poor response from both primary and secondary market players.
The Reserve Bank of India (RBI) brought back capital-indexed bonds (CIBs) to provide investors with an inflation hedge.
In 2004, capital-indexed bonds underwent a structural change, providing protection against inflation for the principal amount and coupon payments.
A market-determined real coupon rate, which stays constant for the duration of the bonds, was applied to the new CIBs, termed inflation-indexed bonds, or IIBs. A predetermined percentage is applied to either the consumer price index (CPI) or the wholesale price index (WPI) to determine the interest rate on CIBs.
What are inflation-indexed bonds (IIB)?
Originally named capital-indexed bonds, the RBI introduced inflation-indexed bonds in 2004 and issued them in 2013 to protect capital investment and offer yields that were adjusted for inflation. These bonds are index-based on the CPI or WPI.
Capital-indexed bonds vs inflation indexed bonds
| Capital-indexed bonds (CIBs) | Inflation indexed bonds (IIBs) |
| RBI issued CIBs initially in 1997 | In June 2013, the Indian government issued IIBs (tied to WPI) through the RBI. |
| Only the principal was protected against inflation; interest payments were not | Both principal and interest payments will be protected against inflation with IIB. |
| The coupon rate was 6%, which was not inflation protected | The coupon rate was fixed at 1.5% |
Advantages and disadvantages of capital-indexed bonds
Benefits of investing in CIBs/IIBs:
- The investor may avoid seeing their funds decrease due to inflation by purchasing these bonds.
- Compared to nominal bonds, they are riskier and more volatile, but they also provide a higher yield.
- Being long-term bonds, they also provide long-term protection against inflation.
- Because of the consistent flow of coupon payments, these bonds may be considered a reliable source of income.
- Due to the large number of reputable issuers, these bonds provide excellent portfolio diversification opportunities.
The downsides of investing in CIBs/IIBs:
- It takes time to choose the inflation index that works most effectively for these bonds.
- While the WPI works well for India’s economy, it may need to do better when it comes to measuring the impact of inflation on individual investors.
- If certain inflation risks associated with these bonds are reinstated, there is a risk associated with taxing them.
Conclusion
Despite certain limitations, like choosing the right inflation index, capital-indexed bonds and inflation-indexed bonds help investors avoid the erosion of capital due to inflation. As inflation hedging tools, CIBs/IIBs have a promising future for investors.
FAQs
The Reserve Bank of India (RBI) first issued CIBs in 1997, which are a type of inflation-indexed bond. There are multiple ways to invest in these bonds, including through the government website, banks, and brokerages.
Indexed bonds adjust their payments according to a specific price index, like the Consumer Price Index (CPI) or the Wholesale Price Index (WPI). The benefits of indexed bonds are that they protect investors from inflation risk, provide a real rate of return, and reduce the volatility of bond prices.
A bond is a fixed-income security that pays a fixed amount of interest and principal at maturity. On the other hand, an indexed bond is a bond that pays interest and principal that are linked to an inflation index.
Whether you should hold a bond index fund depends on your investment goals, risk tolerance, and time horizon. Bond index funds can provide diversification, low fees, and stable income, but they also have interest rate risk, lower returns, and tracking errors.
Inflation-indexed bonds are a good investment for investors who want to hedge against inflation. They pay more when inflation is high and less when inflation is low. They also have lower default risk than other bonds, as they are mostly issued by governments.