Understanding Inflation-Linked Bonds (ILBs)

The recent Monetary Policy released by Reserve Bank of India (RBI) laid its thrust on controlling the spiraling inflation, especially the food price inflation. One of the reasons behind the Cash Reserve Ratio (CRR) hike was to “curtail the rising inflationary expectations (higher expected price trends)”

In the past RBI has been concerned about the fact that a common man does not have any protection against rising prices, vis No Inflation Hedge. The common man has to rely on traditional but inefficient methods to hedge the real inflation risks, such as Gold and real assets such as commodities or real estate or even excessive stocking of goods

In developed markets like US, the government has issues “Treasury Inflation Protected Securities” known as TIPS. Globally more than USD 1 trillion worth inflation linked bonds must be outstanding.

Inflation-linked bonds (ILB) securities give an opportunity to market participants and investors to hedge against inflation. The coupon (interest rate) of ILB is fixed but the underlying principal would move in tandem with the inflation levels in the country. At redemption of the securities the higher of the value (adding inflation) thus arrived or face value is paid off. Banks and Financial Institutions usually buy wholesale and create retail market for such securities. With right access retail investor can easily buy such securities to protect himself from inflation and this could have following advantage to investors and the government.

1. The inflation-linked bonds can make the governments accountable for higher inflation since the cost of borrowings will be linked to inflation (if coupon paid is inflation hedged). Rising inflation will also raise the repayment of inflation linked bonds.
2. It will help government to broaden the investor base by offering inflation linked bonds at the retail level, where the participation now is minimal.
3. Government can diversify the debt service costs in a deflationary (falling prices) scenario.
4. It is very likely that the existence of inflation-linked bonds might reduce the inflation risk premium embedded in government bonds.
5. For the inflation-linked bonds to be an effective hedge GOI should ensure that the underlying inflation index is representative of real or actual inflation on the streets.
6. RBI can precisely quantify & control the inflationary expectations embedded in the economy as well as in the markets. RBI can use inferences from trading in such bonds in formulating its monetary policy stance
7. The onus on monetary policy tools such as interest rates, to contain inflation will reduce if RBI can guide or influence the inflationary expectations through the demand/supply of inflation linked bonds and with an excellent communication policy.

For Investors in general, inflation-linked bonds would provide distinct advantages:

1. It allows investors to hedge the purchasing power (inflation) risk. The capital is inflation risk protected and the income (coupon) can be structured that way too.
2. Inflation-linked bonds universally are regarded as a separate asset class & would provide diversification benefits to a portfolio due to its negative co relation with returns from traditional asset classes.
3. Such bonds provide positive risk reward relationship too.
4. Inflation-linked bonds are effective vehicle for hedging risks for institutional investors, where the long term liabilities are inflation linked or linked to future wage levels or banks who face the inflation risk on their assets side due to their GOI Bond holdings.
5. Access of FIIs to the inflation-linked bonds can allow them to hedge their inflation risks in India which are currently expressed in the currency markets. The USD/INR (currency) volatility can hence come down hence.