Returns on CPI-indexed bonds unattractive
The target market for these bonds has shrunk to retail investors who fall in the lowest tax bracket
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The Reserve Bank of India (RBI) on Friday announced that Inflation Indexed National Savings Securities-Cumulative (IINSS-C) bonds for retail investors will be launched in the second half of December 2013. RBI said the aim is to protect savings from inflation, especially the savings of the low and middle income groups. But does this product really give you an inflation-adjusted return, and should you go for it?
What’s on offer?
The face value of one IINSS-C unit is Rs.5,000. So, you will have to invest a minimum of Rs.5,000. The maximum amount you can invest in a financial year is Rs.5 lakh. The interest rate will be calculated at Consumer Price Inflation (CPI) rate plus an additional fixed rate. The additional margin is 1.5% per annum. For instance, if CPI is at 10%, the IINSS-C will give you 11.5% returns (10% + 1.5%). The interest will be compounded half yearly and the tenor for the product is 10 years. For instance, if you invest Rs.5,000, assuming CPI inflation rate is 10%, the interest accrued after six months will be Rs.287.50 at an annual coupon of 11.5%. Assumed annual interest rate applicable at the end of the next six months, if CPI inflation rate is at 9.5%, will be 11%; then the interest accrued at the end of 12 months will be Rs.290.80. Hence, the total value of investment at the end of 12 months will be Rs.5,578.3. The CPI rate will be used as reference, with a lag of three months. For instance, final combined CPI for September 2013 would be reference CPI for all days of December 2013.
RBI states that you can nominate a sole holder or a sole surviving holder for these bonds. An individual may nominate one or more persons who shall be entitled to the bonds and the payment thereon in the event of her death. Non-resident Indians can also be nominees.
IINSS-C bonds are eligible as collateral for loans from banks, financial institutions and non-banking financial companies (NBFCs). A Permanent Account Number (PAN) is mandatory if you invest Rs.50,000 or more.
The RBI circular states that the bond will be sold/distributed through all agency banks, including Stock Holding Corp. of India Ltd (SHCIL), in the form of bond ledger account. It will be maintained in an electronic format. Banks, including SHCIL, will act as an interface for all customer services related to these bonds, including providing receipts, repayment, record change of address, nomination, transfer and early redemption. Hence, banks will be used as a channel to sell these bonds.
What it means
Tax disincentive: When you consider whether or not to invest in this bond, you have to look at what else is available or what are the choices in the fixed-income space. Let’s leave aside debt mutual funds wherein you essentially invest in an actively managed portfolio rather than one bond. Other than that, you have options such as fixed deposits (FDs), Public Provident Fund (PPF) and tax-free bonds.
This bond does beat FD returns primarily because at the moment nominal FD rates are below the CPI index levels. But, when you look at returns from PPF and tax-free bonds, it’s not so straight forward. One glaring drawback of the inflation-indexed bonds in the current form is the lack of any tax incentive for interest earned, which makes the nominal return less attractive. For example, if the coupon rate for these bonds is 11.5% in a given year, then the post-tax return for that year for someone in the highest tax bracket will be 7.95%. That essentially results in a post-tax negative real return. This is also the case for somebody who falls in the middle tax bracket of 20.6%; the people who make marginal positive real returns are those who pay the lowest tax of 10.3% on their income.
On the other hand, interest earned from tax-free bonds and PPF are tax free for you. Although, even these options don’t offer a positive real return, as things stand now, the interest offered on tax-free bonds for a 10-year tenor and the current PPF rate of 8.7% per annum is more attractive for investors in the highest tax bracket. For those who fall in the 20.6% tax bracket, returns from these bonds are only marginally better than current returns from tax-free bonds and PPF.
It’s only if you are paying tax at the rate of 10.3% that the post-tax return is reasonably positive. At the same time, this bond will give you returns better than the other options we discussed. This is more relevant at today’s high rate of inflation; in the next ten years, if CPI inflation moderates or falls from current levels, then the return on CPI-linked bonds will also fall, but the tax-free bond rate will remain the same at 8.66%. If that happens, the coupon on these bonds will look less attractive across tax brackets.
Says Suresh Sadagopan, a Mumbai-based financial planner, “At 10% CPI, this product will give better returns than bank FDs right now. However, the interest rate will change for these bonds. You can look at investing only a certain portion of your money in this.”
Details are not so favourable: Other than the unattractive tax structure, the bond comes with a lock-in which is also not favourable. For senior citizens, the lock-in period is one year and for others it is three years. If redeemed before maturity, the penalty charges will be at the rate of 50% of the last coupon payable for early redemption. In absolute terms, it may not be much but if you consider the current rate of CPI inflation (10%), the charge could be at least 5% of your invested value—5% assuming that 50% of the last coupon payable refers to the actual value of the coupon. Moreover, for retail investors and senior citizens who pay less tax, though this return may seem attractive, there is no provision for regular interest payout.
According to the RBI circular, interest gets paid out only at maturity. So, the absence of regular income is another sore point for investors in the low-income bracket.
You can buy these bonds through banks. However, for the majority of low-income earners looking for a safe option to invest in, access needs to be widened.
In its current form, this bond leaves a lot to be desired. If the idea was to provide investors a sure shot way of earning positive real returns, that has not happened for many investors owing to the high taxation on this product. In fact, some investors already have at least two other options which work out better. The target market for these bonds has essentially shrunk to retail investors who fall in the lowest tax bracket of 10.3%.