8/22/2014 Mrunal Explained: Inflation indexed Bonds IIB, features, benefits

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[Economy] Inflation Indexed Bonds IIB, IINSS-C: Salient Features, real
interest rate, nominal interest rate
1. Prologue
2. Nominal vs Real interest rate
3. Inflation index bonds: Salient Features
4. IIB: How do they protect against inflation?
5. IIB: Principle also protected
Prologue
Economic Survey Chapter 4: Prices and Monetary Management. FIVE subparts
1. Inflation indexed bonds
2. measures of money supply: M0, M1, M2, M3, M4, Broad-narrow money
3. Monetary policy trends, RBI restructuring
4. Indexes Theory: WPI, CPI, IIP, Services index and others
5. Indexes Current: Survey observations on WPI, CPI & IIP, How to combat inflation
Nominal vs Real interest rate
Real = nominal minus inflation.
Suppose SBI offering 4% on savings account (SA) and 9% on fixed deposit (FD).
These are called NOMINAL interest rates.
But will they protect my savings against inflation?
I can find out via real interest rate
Nominal CPI (Inflation)
Real interest rate
=Nominal MINUS inflation
SA 4.00% 11% -7%
FD 9.00% 11% -2%
Observe that real interest rate is NEGATIVE number. Meaning, inflation will
ERODE my purchasing POWER, IF I invest in savings or fixed deposit.
Therefore, during high inflation, juntaa prefers to invest money in physical assets
like gold, real estate than in financial assets like bank deposits or mutual funds.
Consequences: higher gold import => CAD increased => Rupee weakens =>
crude oil import expensive=> petrol diesel expensive => milk, veggies
everything expensive due to higher transport cost.=> more inflation
8/22/2014 Mrunal Explained: Inflation indexed Bonds IIB, features, benefits
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Thus, a vicious cycle created: more inflation => more gold import.
To break this cycle, what should we do?
Ans. Provide an investment option where Juntaa gets POSITIVE real interest.
And thus, we come to our topic of discussion: inflation indexed bonds.
Decode the words: Bonds=> you are giving money to someone, he gives you a
piece of paper, hell repay interest and principle.
But there is a caveat: this RETURN will be linked to inflation so if more
inflation then hell pay you MORE.
Inflation index bonds: Salient Features
1997: Capital index Bond (CIB) had similar features.
Budget 2013: announced inflation indexed bonds (IIB)
RBI launches two type of IIB
IIB IINSS-C
8/22/2014 Mrunal Explained: Inflation indexed Bonds IIB, features, benefits
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Fullname Inflation indexed bonds
Inflation Indexed National
Savings Securities-
Cumulative
Born
Jun 2013. then more launched in Aug,
Sep, Nov
Dec. 2013. Stopped after
March 2014.
Whocan
invest?
Anyone can file application BUT the
allottment is made in such manner that
80% of bonds allotted to
institutional investors (e.g. LIC,
mutual funds)
20% of bonds allotted to retail
investors.
ONLY retail investors can
apply. Meaning
Individual /NRI
Hindu undivided family
HUF
Charity organization
Educational bodies
Whosells?
RBI directly via auction method.
This money goes to Government.
So in a way, Government is
Borrowing from public.
RBI outsourced the selling
work to
Nationalized bank (SBI
, BoB, PNB etc)
Axis bank
HDFC
ICICI.
Investment
limit
Minimum 10,000
Maximum 25 lakhs
Minimum 5,000
Maximum 10 lakhs for
individual
Maximum 25 lakhs for
charity and educational
org.
Redeem
You can only redeem (i.e. getting
back your principle) after 10
years. Otherwise theyll charge
penalty
Same. But senior citizens
given some relief. They can
pullout money after a few
years.
Trading
They can be traded in secondary
market (via BSE, NSE etc
stockexchange).
but if you sell your bond in
secondary market and make profit,
youll have to pay Capital gains tax.
although in real life, Buyer will
CANNOT be traded in
secondary market (BSE, NSE
etc.) so once you buy, youve
to keep it to yourself. until
the maturity period (10
years).
8/22/2014 Mrunal Explained: Inflation indexed Bonds IIB, features, benefits
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have to withhold & pay. Recall TDS
concept in Vodafone.
IIB: How does it protect against inflation?
So far we learned the salient features of two types of inflation indexed bonds. BUT,
HOW do they protect your investment against inflation?
Return (interest rate) on these bonds
IIB IINSS-C
1.44% + WPI (Base year
2004)
Four month lag
Compounded half yearly
1.5% + CPI (Combined) base year
2010
3 months lag
Compounded half yearly
Explanation, Suppose
1st Jan 2014: Youve invested Rs.10,000 on IINSS-C.
On June 2014, Rajan will count the interest rate to be paid to you. Using CPI
data of four month earlier i.e. Feb.2014
In Feb 2014, CPI was 8.03
Therefore youll earn 1.5+8.03=9.53% interest
So, is your investment protected against inflation? Well we can simply cross check
by finding REAL INTEREST RATE.
nominal MINUS Inflation=REAL interest rate
9.53% -8.03% +1.5%
This time, real interest rate is a POSITIVE number. So, yes, Inflation indexed
bonds protect your savings against inflation.
IIB: Principle also protected
In the above example, youve invested Rs.10000 in IINSS-C.
You redeem after ten years, IF CPI inflation is 60% that time, youll get 16,000
rupees. (This is only for illustration, real calculation has more caveats.)
1997: RBI had launched CIB (Capital indexed bonds). They only protected the
interest from inflation but did not protect principle from inflation.
But both of these new bonds protect your (principle + interest) from inflation.
8/22/2014 Mrunal Explained: Inflation indexed Bonds IIB, features, benefits
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Posted By Mrunal On 22/08/2014 @ 03:20 In the category Economy