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What are Inflation Indexed Bonds

09 Dec 2022 0 COMMENT

In India, inflation linked bonds were first introduced in 1997. The bonds are index linked, with the principal and interest payments being adjusted for inflation. The bonds are issued by the government with full faith and credit.

The purpose of these bonds is to provide a hedge against inflation for investors. The bonds are designed to protect the purchasing power of the investor's capital. Beside, these bonds have become increasingly popular as investors seek to protect their wealth from inflation.

The Indian government has been issuing inflation linked bonds since 1997 and since then it has proved to be popular with investors seeking to protect their wealth from inflation. The Bonds have provided a hedge against inflation and have helped to preserve the purchasing power of investors' capital.

What is inflation indexed bonds?

It is a type of bond that is designed to protect investors from the effects of inflation. The interest rate is linked to an index, such as the Consumer Price Index (CPI) and is adjusted intermittently to keep pace with inflation. This type of bond is an attractive investment to preserve the purchasing power of finance over time.

Such bonds are a kind of debt security in which the face value of the bond rises with inflation and falls with deflation, as measured by an official price index. The real return on the bond is equal to the coupon rate minus the rate of inflation.

The value of an inflation-indexed bond is calculated by adding the face value of the bond to the product of the change in the index since issuance and a constant called the gearing ratio. The gearing ratio is generally close to one.

Features of inflation indexed bonds

Coupons shall be paid midyear. The calculated coupon rate shall reimburse on an adjusted principal.

The principal aim is to safeguard economy of the poor and middle classes.

The minimum individual investment is Rs 5000, with a maximum of Rs 10 lakh per year. The maximum institutional investment is Rs 25 lakh per year.

How is interest on an inflation-indexed bond calculated?

The principal amount is typically indexed to inflation. This means that as inflation rises, the principal value of the bond also increases. The interest payments on an inflation-indexed bond are calculated using the formula that takes into account the current level of deficit finance.

For instance, if the rate of inflation is 3%, and the interest rate on the bond is 5%, then the interest payment would be calculated as 5% of the current principal value, plus 3% of the original principal value.

How does inflation index bond work?

The principal and interest payments on inflation-indexed bonds are to be adjusted for changes in the consumer price index. The CPI is used as a means of the average change in prices reimbursed by consumers for a basket of goods and services. It is used to calculate the rate of inflation.

Inflation-indexed bonds are an effective way to hedge against inflation. The bonds are issued by governments in order to finance their budget deficits. Interest on the bonds is paid semi-annually. These bonds are designed to protect investors from the effects of inflation.

How to invest?

There are multiple ways to invest in these bonds, including through the government website, banks, and brokerages.

Inflation Indexed National Saving Securities - Cumulative and Index Funds-ETFs are the two most common ways to purchase inflation indexed bonds in India. The Indian government offers these bonds as a way to help savers safeguard the money from the effects of inflation.

Investors can purchase inflation indexed bonds through banks, brokerages, and online platforms.

Should you invest?

Inflation is one of the biggest dangers to your wealth. It slowly reduces the purchasing power of your money, meaning you can't buy as much with it as you could have in the past.

One way to combat inflation is by investing in inflation-indexed bonds, also known as real return bonds. These bonds offer a guaranteed rate of return above inflation, protecting your purchasing power and ensuring your investment grows.

However, there are some risks to consider before investing in these bonds. Inflation-indexed bonds are generally issued by governments, so they're subject to the same political risks as other government debt. Additionally, these bonds typically have lower interest rates than traditional bonds, so you may not earn as much in interest payments.

Despite the risks, inflation-indexed bonds can be a valuable addition to your portfolio.

Pros

They offer protection against inflation. This is because the payments on these bonds are adjusted according to the rate of inflation, so you will not lose purchasing power over time.

Second, these bonds have low interest rates compared to other types of bonds, so they can be a good choice for income investors.

Finally, inflation-indexed bonds tend to be less volatile than other types of investments, so they can provide stability for your portfolio.

Cons

They have less earning potential than other securities. The interest rate on these bonds was calculated using the formula that takes into account the change in the consumer price index, not the actual rate of inflation.

They are not a perfect measure of inflation. The Consumer Price Index does not include everything that people buy and so it may not be an accurate measure of the true cost of living.

Finally, these bonds can create phantom income. This happens when the interest payments on the bonds increase due to inflation but the value of the bond does not keep pace with inflation.

The principal value of the bond is protected from inflation; any interest payments made on the bond are not. So if you're relying on the interest payments from your bonds to help cover living expenses in retirement, those payments may not go as far as you'd like if inflation rates are high.

Conclusion

These bonds can be considered as a great option to invest money and ensure that it keeps up with the rate of inflation. They are a secure investment and have a government guarantee. This makes them a low risk investment for those looking to keep their money safe and grow it over time.

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