Would you like to buy a bond that not just gave you guaranteed interest at an increasing rate but also doubled your principal in 20 years? If I were about to retire, I’d queue up to buy this product. And maybe even pay a transaction fee on it.
One of the biggest worries a person retiring today faces is that of his corpus losing more than half its value in 10 years and worse, the interest stream buying fewer and fewer goods each passing year. Inflation dislikes retired people and maliciously takes incrementally larger bites out of their consumption basket, year on relentless year.
Let’s assume that Mr Rao is retiring today and can invest in two bonds. He has Rs10 lakh to invest and must choose between a traditional 20-year bond that throws off an annual 5% return and at the end of 20 years returns the Rs10 lakh. With inflation at an assumed 4% a year, the value of that money is just Rs4.42 lakh at the end of 20 years. The final year interest payment of Rs50,000 a year is worth Rs22,000.
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Since I am in the “what-if” zone these days, let me ask this question: What if there was a bond that was linked to the inflation rate? If it were, then Mr Rao will now eat chicken at 80 (using dentures that his own money bought— he wouldn’t need to nudge the kids), because he bought a bond called RRIPB (retail RBI inflation protection bond).
Though the bond does not exist today, it could. If it did, it would look something like this: The principal Rs10 lakh is now indexed to an inflation index, ideally the Consumer Price Index (CPI). If inflation is at 4%, at the end of the year, Rs10 lakh becomes Rs10.4 lakh. The interest at 5% is not on Rs10 lakh, but on the inflation-indexed amount and Mr Rao would get a cheque of Rs52,000 at the end of the first year. Not exciting yet.
But wait till year six. Then Mr Rao, on his morning walk with Mr Singh, would begin to talk about this wonderful product for he would have just got an interest cheque of Rs60,833 and his account statement showed that his principal was now at Rs12.16 lakh. By year 10, Mr Rao would be crowing with joy—his interest cheque is now at Rs74,012 a year and his corpus is Rs14.8 lakh. At 80, or 20 years later, Mr Rao would still be eating chicken, his interest cheque would stand at Rs1.09 lakh and his corpus would have more than doubled to Rs21.91 lakh.
The good news for Mr Rao is that these bonds exist in the world. The bad news is that the two times the Reserve Bank of India (RBI) experimented with them, they did not work.
Known as capital-indexed bonds, these are fairly well known in many parts of the world. The most popular ones are known as TIPS or the treasury inflation protected securities in the US, where the interest rate remains fixed, but the principal gets adjusted to match changes in a price index such as CPI, like the fictitious RRIPB.
The other type of bonds see the interest rate also adjusted according to inflation. The utility of these bonds is clear to us in India as we periodically face inflationary food baskets, but the US saw limited response for these bonds in the long years of Alan Greenspan’s largesse as chairman of the US Federal Reserve.
India has experimented with these bonds twice, once in 1997 and the second time in 2004.
In 1997, only the principal was inflation indexed and not the interest, while in 2004, both principal and interest were inflation indexed to the Wholesale Price Index (WPI). Both times the bonds did not work due a variety of factors, the chief being the lack of a credible benchmark that the market would trust.
The problem with using the WPI for such a bond shows up in the current divergence of the CPI and the WPI. But it isn’t as if this problem cannot be solved.
Economist Ajay Shah says that a top-quality weekly inflation measurement would cost not more than Rs5 crore a year. “So, while today we are stuck with bad-quality inflation measurement, this is a problem that is easy to overcome. Someone’s just got to have the incentive to do it,” he says.
There is a clear public good in a retail issue of an inflation-indexed bond issue from RBI. The retail success of its 8% savings bonds 2002 should prove that such a market exists at the retail end and is hungry for useful paper.
RBI will have to get the index and taxation issues right for the bonds to work at the retail level. The products are needed and will fill a large gap for people who have very few investment options that give guaranteed returns in an economy that is fast transferring risk to the individual.
Next week: Why zeros are heroes.
Monika Halan works in the area of financial literacy and financial intermediation policy. She is consulting editor with Mint and adviser, Pension Fund Regulatory and?Development Authority. Comments are welcome at email@example.com