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How inflation indexed bonds work? How to invest in inflation indexed bonds?

Updated on February 24, 2016

How inflation indexed bonds work? How to invest in inflation indexed bonds?

Inflation indexed bonds are an innovative financial product that act as a hedge against inflation. There are many ways to invest your money. Let’s say you have invested Rs. 10000 in your bank and let’s assume your bank pays an annual interest rate of 7%. At the end of the year, you have earned Rs. 700 as interest. You now have Rs. 10700 in your kitty. However, if the economy has inflated by 7% at this point in time, i.e if the cost of various goods and services in the country has increased by 7%, your money will lose value. In this case, the extra Rs 700 earned through interest will be nullified by inflation. Inflation indexed bonds provide inflation protection against the principal amount as well as interest payments. The interest rate is called Coupon.

Like Gold, Inflation indexed bonds are an excellent hedge against inflation. You can buy these bonds to diversify your investment portfolio. According to experts, these bonds are ideal for all class for investors, especially retail investors.

Right now, Inflation indexed bonds are linked to the wholesale price index (WPI). In December 2013, RBI launched Inflation indexed national savings certificate-cumulative (IINSS-C) to target retail investors. These were linked to the Consumer Price index (CPI), an index which captures inflation more accurately. Right now, the minimum investment in these bonds is Rs 5000 and the bond tenor is 10 years

Here is how they work: For example, the annual coupon of a bond is 10% and the principal is Rs. 100. If the inflation index rises by 12% in the next year, the principal amount will be adjusted to the inflation rate. In this case, it will be adjusted to Rs. 112. The following year, you will earn Rs 11.2 as interest.

Calculation formula: Principal = original principal * (current WPI/WPI index at issue time)

Ordinary bonds vs Inflation indexed bonds: Below is a comparison between ordinary bonds and inflation-indexed bonds

The ordinary bond will pay Rs 100 to the bondholder till maturity but the Inflation indexed bond adjusts to the inflation rate prevalent during the year. At the final year, the higher of the original principal or inflation adjusted principal is paid to the bondholder.

Drawback: In some cases, the economy may undergo deflation. Deflation is the opposite situation of inflation i.e the value of money will go up and that of goods and services will come down. In such cases, the principal will get reduced in order to adjust to deflation. However, such a scenario is a very remote possibility in India as we are a developing economy

How to buy and sell Inflation indexed bonds? The RBI conducts auctions for regular government securities (G-secs). You can buy bonds of Rs. 10,000 face value.

In India, Inflation indexed bonds are being sold by a number of banks like SBI, Axis Bank, ICICI bank etc. The minimum amount one can invest is Rs. 5000 and the maximum amount is Rs 10, 00,000. You will just have to fill up the relevant forms and submit to these institutions

You need a demat account to participate in these bonds. Since inflation indexed bonds are G-secs, investors can trade them in stock exchanges.

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