Interest in inflation- indexed bonds, but clarity needed on structure

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The prospect of good return at low risk is set to attract participation from institutional investors, including insurance companies, in inflation- indexed bonds. This new category of securities, likely to be auctioned next month, are papers which usually guarantee a return higher than the rate of inflation if held to maturity.

Investors, especially from the insurance front, are seeing good opportunity here. It will be beneficial for long- term investors. On the retail side, too, it will be ideal for people who depend on bond returns to manage expenses. However, the final verdict will be on the basis of how the market responds.

The bonds, which will protect the principal and the interest components from inflation risks, could have a fixed coupon rate and a spread ( plus or minus), depending on the bids. The interest rate will be calculated on the principal amount, adjusted to inflation. While it is expected that the bonds would be linked to the Wholesale Price Index ( WPI), with an option to redeem the bond after five to six years, insurance company officials said getting it linked to the Consumer Price Index ( CPI) could not be ruled out.

While the new securities look interesting from a market perspective, and we are looking at its prospects, we need some clarity on how the coupon rate will be calculated.

Some companies have begun brainstorming on the nitty gritty of participation in this category. The target audience for it, according to investment officers of insurance companies, would be the middle and upper middle class. Further, while some sections of the market anticipate the Reserve Bank of India ( RBI) might dictate the prices of these bonds, CIOs of life insurers maintained RBI would not interfere and prices would be determined by auctions (on price and yield).

Earlier story

Inflation- indexed bonds have been introduced earlier. Market players said these existed in the 1999- 2000 period but did not see much participation, due to low awareness. While there is a fear among a section of market participants it might meet a similar fate as floating rate bonds, others said the latter did not see much activity due to limited issuances and an unattractive benchmark.

Floating rate bonds were not very successful because the benchmark the issuers were using was very sticky and were not moving in line with the rate rise. However, he added, it was very unlikely that the CPI would be used as the index, since it is very volatile and has most of the weightage in food and fuel.

WPI depicts a wider picture of inflation. But WPI is understating the actual inflation.

Investors will be compensated for WPI inflation and this would have a market, with a fair chance of success.

For instance, if WPI is seven per cent, the rate of return could be eight per cent. Insurers said this was a better rate of return than fixed income bonds; the latter, on an average, offer a return of 7- 7.5 per cent. If linked to the CPI, the rate of returns could be much higher.

Disadvantages

However, some have a conservative view. In the institutional market, the appetite might not be great because if it was linked to inflation numbers, it is a question mark in terms of construction. There is lack of a reliable component structure for the underlying index. You are also not in a position to take a medium- term view, based on the previous month inflation numbers. Similarly, the retail participation in government securities has been very poor. I do not see a major appetite even from the retail side, unless there is a significant upward trend in inflation.

Timing- wise, it is not a right time to launch these bonds because inflation is expected to come down.

BIG BOND

|This new category of securities usually guarantees areturn higher than the rate of inflation if held to maturity |The bonds could have a fixed coupon rate |The bonds might be linked to the Wholesale Price Index |Insurance company officials say getting it linked to the Consumer Price Index cannot be ruled out

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