Theres going to be a welcome addition to the Indian debt market this June, as the Government

launches its first tranche of Inflation Indexed Bonds (IIBs) on June 4, 2013 for Rs. 1000-2000 cr. to fulfill a
key budget promise. http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=28671
Lately Indian economy is going through a lot of turmoil. On one side, it has an unsustainable Current
account deficit (CAD) due to large gold imports, a weak rupee, slowing down of industrial growth and
continuing high inflation. In this highly inflationary environment with CPI hovering at 10%, fixed income
investors are seeing their returns being eaten away with a negative real yield on their investments as a
result of low interest rates (last one year, RBI has cut its repo rate by 125bps). While keeping investors
interests in mind, the Reserve Bank of India planned to launch inflation-indexed bonds, a boon during
times of high inflation.
The inflation numbers
The number of goods that are representative of a particular economy put together as something called
the basket of goods. When the cost of the basket is compared over time, it results into a price index.
In India, major indices are used to measure overall inflation in the economy are Wholesale price Index
(WPI), Consumer Price Index (CPI) and GDP deflator and is published by the Office of Economic Adviser,
Ministry of Commerce and Industry. Depending on what goods or items the basket is made of, the price
inflation is measured and categorized into food inflation, non-food inflation, industrial inflation etc.
WPI, considered as headline inflation, has a basket of 676 items taking 2004-05 as base year. The idea
behind this measure is to capture the bulk sales/transactions happening in the domestic market and
includes food items, non-food items, fuel, power and manufactured goods. Monthly WPI is closely
tracked by RBI for its monetary policy.
CPI, on the other hand, measures the inflation more from a retail buyer perspective. It is the index which
most Indian households should be worried about as it reflects the actual inflation borne by the
individual. The CPI is reported for three different segments namely Industrial Workers (IW), Agricultural
laborers (AL) and Rural Laborers (RL). Central Statistics Office (CSO) started reporting a new series (NS)
from Feb 2012 which includes CPI for entire urban and rural population. This new series is wider in
scope compared to WPI as it reflects the changes in the price level of various goods and services
consumed by urban and rural population combined.
How inflation affects bond returns?
Before we attempt to understand how IIB would hedge an investor from the inflation, we need to
understand how the rate of inflation affects the yield on a nominal fixed income security. It is all
governed by a simple equation called Fisher equation. Fisher equation assumes following form I F= Y, where I = nominal yield, Y = real yield and F = inflation expectation (ex-ante) or real inflation (expost). What it basically tells is that in a healthy financial system, interest rates in the market incorporate

inflation expectations, so as to give depositors a positive real return. Here, nominal yield on a bond is
the return on bond as fixed percentage of par value or its coupon rate. Other factors affect this rate such
as credit risk of the issuer, rating of the issuer, bonds maturity etc. The greater the risk, more the
premium investors will ask. For e.g. in case of a long term bond (30 yrs), in the long term investor may
see the credit risk of issuer rise, uncertain inflationary condition leading to unpredictable return. Hence,
investors ask additional compensation in terms of greater yield on the bond for taking that long term
risk.
Y is the real yield of the bond that an investor is worried about excluding the risks arising from inflation.
Inflation is nothing but loss of purchasing power of the money. So, If I have two options of either holding
100 rs for one year with an inflation of 5% or investing in a bond of face value 100 rs giving 8% return, I
see that by holding rs 100 for an year, I am losing rs 5 because after one year that rs 100 will be worth
95 due to inflation. However, by investing in a bond, it will be worth 108. So, the real yield that I get by
investing in a bond incorporating 5% inflation is 8%-5% = 3%. So, it means that to get a positive real
return on my investment I need to have nominal yield more than the inflation expectation.
Higher Inflation generally leads to a higher interest rate environment. When the inflation rate rises, the
expected real yield on the bond decreases. The price of a bond drops, because the bond may not be
paying enough interest to stay ahead of inflation. Remember that a fixed-rate bonds coupon rate is
generally unchanged for the life of the bond.
The longer a bonds maturity, the more chance there is that inflation will rise rapidly at some point and
lower the bonds price. Thats one reason bonds with a long maturity offer somewhat higher interest
rates: They need to do so to attract buyers who otherwise would fear a rising inflation rate.
How IIB is indexed to Inflation?
Since the inflation reduces the real yield on a bond by decreasing the future cash flow earnings or capital
gains (Y = I F). An inflation indexed fixed income security can be linked to any price index i.e. by
adjusting it to inflation at that point. In IIBs case, the coupon rate and principal repayments are
adjusted in line with an inflation index which in this case is WPI. What IIBs really do is adjust the coupon
yield I of the bond by indexing principal P to inflation F thereby varying it inline with variations in F
eventually keeping real yield Y constant.
Launch of IIBs confused investors a bit as these instrument seemed similar to Capital Indexed Bonds
(CIBs) launched during 1997. Recently in FAQ (http://rbi.org.in/Scripts/FAQView.aspx?Id=91) released by
RBI clarified that both the products are different from each other as described below

The CIBs issued in 1997 provided inflation protection only to principal and not to interest
payment.
New product of IIBs will provide inflation protection to both principal and interest payments.

The index ratio for IIB is calculated as below

Index Ratio (set date) = Ref WPI (set date)/Ref WPI (Issue date) which is equal to (1+inflation %).
Where set date is settlement/coupon date and issue date is date at which bond was issued.
Here principal is adjusted by inflation compensation as follows
Modified Principal Set Date = (Principal Index Ratio

Set Date)

Hence the coupon is arrived as Coupon C = Modified Principal Set Date x Coupon real yield/2

Final WPI is release on a monthly basis (14th of every month) with a lag of two and half months. i.e. a
WPI released in 14th may 2013 would be for the month of March 2013. Presently, Office of the
Economic Adviser, Ministry of Commerce and Industry, GoI releases a provisional WPI number with a lag
of two weeks and final WPI with a lag of two and half months. Final WPI may deviate widely from the
provisional WPI. In case of IIB, final WPI may be used for indexation to eliminate the uncertainty. If we
see the trend of key inflation indices below, we see a clear divergence between the WPI and CPI indices.
For calculating the index ratio for a specific date, daily WPI values would be linearly interpolated using
Ref WPI for the first day of the calendar month and the first day of the following calendar month. The
formula for computing the index ratio for a particular day is as under:
Ref WPI (set date) = Ref WPI(M) + (t-1)/D * {Ref WPI (M+1) - Ref WPI (M)}
Where Ref WPIM = Ref WPI for the first day of the calendar month in which Date falls, Ref WPIM+1 =
Ref WPI for the first day of the calendar month following the settlement date, D = Number of days in
month (e.g. 31 days in August), and t= settlement date (e.g. August 6).
How it will be priced?
Government will decide the coupon yield on the IIBs by bidding in auctions. In the primary auction, the
IIB would be issued at par and investors would be asked to quote their bids in terms of real yield. So, the
settlement price would be the par value of the bond in the primary auction. During re-issuance or in
secondary market, investors can bid in terms of price or real yield.
In the first tranche, only primary dealers are eligible and retail investor would not be able to participate.
The good part is that these IIBs will qualify for repo, SLR, and short selling. Like any other govt bond,
subject to limits like minimum size/liquidity etc. So banks by holding them can put them as collaterals or
hold them as part of regulatory reserves.
What remains to be seen is what kind of uptake IIBs will see in the retail segment as this is the segment
which has borne the real brunt of inflation. If IIBs could catch investors fancy, government would really
be able to steer these investors away from gold and related investments. This could release some
pressure from current account.