Previous Year Question
With reference to the Indian economy, what are the advantages of ‘Inflation-Indexed Bonds (IIBs)’?
Government can reduce the coupon rates on its borrowing by way of IIBs.
IIBs provide protection to the investors from uncertainty regarding inflation.
The interest received as well as capital gains on IIBs are not taxable.
Which of the statements given above are correct?
1 and 2
2 and 3
1 and 3
1, 2 and 3
Correct Answer: A
Detailed Solution
An Inflation-Indexed Bond or IIB is a debt security in which the principal and/or interest payment received by the investor is linked to a recognised inflation index. Its purpose is to protect the investor’s real purchasing power against erosion caused by inflation.
According to the RBI’s account of IIBs in India:
A five-year Capital Indexed Bond was issued in 1997. It protected only the principal against inflation.
WPI-linked Inflation-Indexed Bonds were issued in June 2013. Both principal and coupon flows received inflation protection.
CPI-linked Inflation Indexed National Savings Securities were issued for retail investors in December 2013.
Statement 1 is correct.
In an ordinary fixed-rate bond, the investor bears the risk of future inflation. Therefore, the investor seeks compensation for both the required real return and expected inflation:
Nominal Interest Rate ≈ Real Interest Rate + Expected Inflation
The investor may also demand an inflation-risk premium because future inflation is uncertain.
In an IIB, the principal or coupon payment is linked to an inflation index. This reduces the need for the investor to demand a large separate inflation-risk premium. Consequently, the Government may offer a lower fixed coupon rate on an IIB than on an ordinary nominal bond.
For example, if an investor requires a 3% real return and expected inflation is 5%, an ordinary bond may require a nominal coupon of approximately 8%. An IIB may offer a real coupon of approximately 3%, with the inflation adjustment separately provided through the indexed principal.
However, a lower coupon rate does not mean that the Government’s total real borrowing cost will always be lower. If inflation becomes very high, the indexed principal and the coupon payment based on it may increase. The statement refers only to the Government’s ability to reduce the coupon rate; therefore, it is correct.
Statement 2 is correct.
In an ordinary bond, higher inflation reduces the real purchasing power of fixed interest and principal payments. In an IIB, the principal and coupon flows are adjusted in accordance with the inflation index.
For example, if the bond principal is ₹1,000 and the relevant inflation index rises by 6%, the inflation-adjusted principal, in a simplified illustration, may become approximately ₹1,060. If the coupon rate is 3%, the coupon may be calculated on the adjusted principal:
₹1,060 × 3%= ₹31.80
Thus, instead of receiving ₹30 on the original face value of ₹1,000, the investor receives a higher coupon based on the inflation-adjusted principal. An IIB consequently protects the investor against inflation uncertainty and purchasing-power erosion.
Statement 3 is incorrect.
IIBs do not enjoy a general or blanket tax exemption.
Interest received from an IIB may be taxable under the applicable provisions of the Income-tax Act.
Capital gains arising from the sale or redemption of the bond may also be taxable according to the applicable holding-period and tax provisions.
Inflation protection does not automatically make either interest income or capital gains tax-free.