Pursuant to the announcement made in the Union Budget for 2013-14 to introduce instruments that will protect savings of poor and middle classes from inflation and incentivize household sector to save in financial instruments rather than buy gold, RBI, in consultation with Government of India, has decided to launch Inflation Indexed Bonds (IIBs).

For appropriate price discovery and market development, it is however, necessary to issue comparable instruments through auctions to the institutional investors such as Pension Funds, Insurance, and Mutual Funds etc. This will create demand for IIBs and help in making them tradable in the secondary market. It is therefore proposed to issue initial series for all categories of investors including institutional investors and, later, another series, exclusively for retail investors. New product of 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.

An example of cash flows on IIBs is furnished below.

Capital protection will be provided by paying higher of the adjusted principal and face value (FV) at redemption. If adjusted principal goes below FV due to deflation, the FV would be paid at redemption and thus, capital will get protected.

The consumer price index (CPI) reflects the inflation people at large face and therefore, globally CPI or Retail Price Index (RPI) is used for inflation target by the Central Banks as well as for providing inflation protection in IIBs. In India, all India CPI is being released since January 2011 and it will take some time in stabilizing. 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.

A non-competitive scheme has been devised for participation of such investors in the auction. Under this scheme, investors are required to indicate the amount of their bids and not the price at which they want to subscribe. Allocation to such investors is made at the weighted average price emerged in the competitive bidding. Presently in auction, up to 5 per cent of the notified amount is reserved for non-competitive bidding, while up to 20 per cent of the notified amount will be earmarked for such bidding in case of IIBs to encourage retail participation. The retail investors will be able to participate in non-competitive bidding through primary dealers (PD) and banks. They can open a gilt account with PDs and banks or demat account for such participation.

This article is written by Dr. K.T. Rangamani . He is a Senior Professor at VIT Business School.