CPI (Consumer Price Index) inflation linked bonds are being issued by the government for retail investors. The first issue is open for investors on 23rd December 2013 and closes on 31st March 2014.The issuance can be closed earlier than March 31, 2014 with a prior notice. Is it a worthwhile investment?
Our analysis suggest that if CPI stays constant at 10% throughout a ten year period, the annualized yield is 11.83%. However CPI is not expected to stay at 10% levels as if it does, the economy will flounder and nominal rates would be much higher than 11.83%.
CPI inflation would ideally come off from 11.24% levels as of November 2013 to levels of 6% and below as government and RBI focuses on keeping down CPI. In this scenario annualised yields would be well below 11.83%, and may even go down to 8% to 9%. The risk to returns would arise if CPI goes below 6% in a short period of time, thereby lowering returns further.
Should one invest in CPI linked bonds? Given that inflation expectations would fall from here on, it does not make a great investment choice. However compared to PPF or Post Office Savings Schemes, it fares reasonably well though there is no steady cash flows and liquidity come at a price. Retail investors who invest in PPF and Post Office Savings Schemes can look at CPI linked bonds as another savings avenue.
CPI Linked Bond Details
Government of India is issued CPI linked bonds with 10 years maturity called Inflation Indexed National saving securities only for retail investors.This issue will opened for subscription on December 23, 2013 and closed on December 31, 2013.
Face value per security – RS 5,000 and minimum investment – Rs 5,000.
Maximum investment – Rs 500,000 per applicant per annum.
Rate of interest (per annum) –real interest rate (fixed rate) + inflation rate.
Real interest rate – 1.5% per annum and the same will act as floor.
Compounding – Half-yearly
Fixed rate of 1.5% would act as a floor, 1.5% per annum interest rate is guaranteed if there is deflation. Interest rate is payable on half-yearly basis. Interest rate will be compounded in the principal on half-yearly basis and paid along with principal at the time redemption.
Early redemption is possible for these bonds. But after one year from date of issue for senior citizens above 65 years of age and 3 years for all others. The penalty charges at the rate of 50% of the last coupon payable for early redemption. Early redemptions to be allowed only on coupon dates. Investor may nominate one or more persons who shall be entitled to the bonds and the payment thereon in the event of his death. These securities are eligible as collateral for loans from banks, financial Institutions and Non-Banking Financial Companies, (NBFC).
How to value IINSS-C?
CPI is used in process of calculating of cash flows for IINSS-C. Combined CPI will be used as reference CPI with a lag of three months (i.e. final combined CPI for September 2013 would be reference CPI for all days of December 2013 and CPI for June 2014 final combined for March 2014 will be used). In case of change in the base year, the base splicing method will be used.
There will be two parts in the interest rate. Fixed rate of 1.5% per annum and CPI inflation rate. Suppose if inflation rate during the six months is 7%, then interest rate for this six months would be 7.75% (i.e. fixed rate 0.75% and inflation rate 7%).
These bonds would be distributed through all agency banks, including Stock Holding Corporation of India Ltd (SHCIL) .The banks, including SHCIL, would act as interface for all customer services related to these bonds (such as receipts, repayments, recording change of address, nomination, transfer, early redemption, lien marking, etc.).
Table 1: CPI Linked Bonds Simulated Analysis