With reference to the Indian economy, what are the advantages of Inflation-Indexed Bonds (IIBs)? Gov

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?

Accepted Answer

Inflation-indexed bonds in India were issued by the Reserve Bank of India (RBI) in 2013 and were benchmarked to Wholesale Price Index (WPI). Inflation-indexed bonds are financial instruments that attempt to protect the bonds' purchasing power by tying interest and principal payments to an index of price changes. Indexed bonds include two types of compensation, a real rate of return plus a compensation for the erosion of purchasing power.The inflation component on principal will not be paid with interest but the same would be adjusted in the principal by multiplying principal with index ratio (IR). At the time of redemption, adjusted principal or the face, whichever is higher, would be paid. Interest rate will be provided protection against inflation by paying fixed coupon rate on the principal adjusted against inflation. Hence statement 2 is correct.Economists have argued that inflation indexed bonds could reduce government borrowing costs. If the market overestimates future inflation, government will reduce borrowing costs by issuing inflation indexed bonds rather than nominal bonds. This may occur because, for example, investors’ expectations are not completely forward-looking or rational. Alternatively, the government, because it is able to influence inflation through its policies, may have better information about the future course of inflation, or perhaps has more faith in its commitment to contain it than the public does. In these cases a treasury can lower its costs by issuing indexed bonds.For example, if coupon rate of IIBs is fixed 1.5% above WPI (Wholesale Price Index) and current WPI is 4%, so effective rate will be 5.5% (4+1.5). In future, when WPI falls from 4% to 2%, then effective coupon rate will become 3.5% (i.e. 2+1.5) and thus government can reduce the coupon rates on its borrowing by way of IIBs through reducing inflationary trends. Hence statement 1 is correct.Extant tax provisions will be applicable on interest payment and capital gains on IIBs. There will be no special tax treatment for these bonds. Hence statement 3 is not correct.