Inflation cut 100 to 14 in 30 years
Inflation is often called the ‘silent killer’ because it significantly erodes the purchasing power of money over time. To establish a frame of reference, consider this: At 6.5% long-term WPI (wholesale price index) inflation in India, the purchasing power of Rs 100 has eroded to a dismal Rs 13.80 over the last 30 years! As time goes on, every rupee you have saved will buy you fewer and fewer goods or services — a scary thought indeed!
In search of ‘real’ returns
In general, conventional fixed income instruments in India have not provided investors with ‘real’ returns, that is, returns over and above inflation. Over the last 30 years, an investor who diligently invested in one-year bank fixed deposits (FDs) every year would have generated real returns of just 1.6% per annum on a pre-tax basis, which after taxes would be insignificant.
On the other hand, a real asset such as gold has generated higher real returns of approximately 3.3% per annum over the WPI inflation rate. It’s no wonder then that Indians have developed a strong affinity towards the yellow metal.
Over the same 30-year period, equity generated substantial real returns of approximately 8.45% per annum over the WPI inflation rate. However, this has been accomplished at the cost of significant volatility.
The lack of real returns in fixed income investment products has only enhanced the lure of the yellow metal, and its ever increasing imports have depleted our foreign exchange reserves.
Concerned with this phenomenon, in June 2013 RBI launched the ‘Inflation Indexed Bonds’ (IIBs). These are based on WPI as well as the consumer price index (CPI) inflation rate.
However, the latter is targeted only towards retail investors with a maximum investment limit of Rs 5 lakh, while the WPI series is targeted at institutional investors and HNIs and has no upper limit for investments in these instruments.
UK and US lead the way
Not surprisingly, such securities are very popular globally. The ‘inflation-linked’ securities originated in the UK in the 1980s, followed by other countries such as Australia and Canada. In the UK, these ‘Linkers’ account for approximately 22% of the t o t a l o u t – s t a n d – ing government debt. The US was a relatively late entrant in 1997 and the issuance of approximately $1 billion of TIPS (Treasury inflation protected securities) accounts for nearly 8% of the total government debt.
In India, we have only one security (1.44 IIGS 2023) with an issuance of Rs 6,500 crore, which is less than 0.20% of the total government debt of approximately Rs 35 lakh crore. The 1.44 IIGS presents an attractive value proposition for fixed income investors as it currently trades at a real yield of about 3.85%, which is higher than the past returns of gold. Given historical WPI inflation of approximately 6.7%, a similar bond issued 10 years earlier would have fetched investors a handsome 10%+ return on sovereign risk.
Expect Innovation around IIBs
Unfortunately, the financial services industry has been slow to catch on to the potential of the IIBs and we have hardly seen any product launches around it. Going forward, we expect innovative product construction to encourage investor participation in this space.
Imagine a fixed maturity plan (FMP) of a mutual fund buying these IIBs and holding them to maturity. Investors in such a fund will beat inflation handsomely, would not be concerned with interim volatility, and can enjoy the benefits of indexation as well. Similarly, imagine a children’s education plan that will beat Inflation significantly, thus protecting the real value of the corpus saved for the child’s bright future.
To summarize, IIBs are a low-risk, perfect hedge against inflation and must, therefore, be part of any long-term debt portfolio. The fact that they are currently trading at attractive levels is an icing on the cake and should encourage investors to participate in them.
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