With reference to the Indian economy, what are the advantages of “Inflation-Indexed Bonds (IIBs)”?
- The government can reduce the coupon rates on its borrowing by way of IIBs.
- IIBS provide protection to 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 only
- 2 and 3 only
- 1 and 3 only
- 1, 2 and 3
Explanation
Statement 1 is correct
- IIBs are bonds in which both coupon payments and Principal amounts are protected against inflation. The inflation index used in IIBs may be the Wholesale Price Index (WPI) or the Consumer Price Index (CPI).
- Since the principal and interest payments of IIBs are adjusted based on inflation, the government can offer lower fixed coupon rates. This is because the real return to investors is protected by the inflation adjustment.
- Let us take an example to understand how IIBs work: Suppose an investor purchases an IIB with a face value of Rs. 10,000, a ten-year maturity, and a coupon rate of 3% above inflation. If the inflation rate is 4% at the time the bond is issued, the investor will receive an annual interest payment of Rs. 312 (3% of INR 10,400) in the first year.
- If the inflation rate increases to 5% in the second year, the investor will receive an annual interest payment of Rs. 327.60 (3% of INR 10,920) in the second year.
- The coupon rate will remain at 3% above inflation throughout the ten-year tenure.
- This process continues until the maturity of the bond, ensuring that the investor receives a fixed income stream that keeps pace with inflation.
- If the inflation rate is lower than the fixed interest rate, then the total interest payment would be lower than the fixed rate. On the other hand, if the inflation rate exceeds the fixed interest rate, the total interest payment would be higher, providing investors with some protection against inflation.
Statement 2 is correct
- IIBs are designed to protect investors from inflation by ensuring that the principal and interest payments are adjusted according to the inflation rate, thereby preserving the real value of the investment.
Statement 3 is incorrect’
- In India, both the interest received and capital gains on IIBs are taxable. While interest income is subject to income tax, capital gains from the sale of IIBs are taxed under the capital gains tax regime.
