What Happened to India's Inflation Indexed Bonds?

One of the key factors in determining how individuals deploy their savings is the rate of return on any investment. Crucially, the rate of return should ideally be higher than the prevailing or expected rate of inflation. Otherwise, in ‘real’ terms, a person will see the value of their savings or investment erode over a period of time as it will be able to purchase fewer and fewer items on account of an increase in prices.

This, invariably, tips the balance in favour of market-linked instruments such as mutual funds and renders fixed-income options like bank deposits as secondary after one has exhausted their tax-saving limits.
 

However, one debt instrument that offers the more risk-averse savers a middle path is an inflation-indexed bond.
 

Understanding inflation-indexed bonds

As the name suggests, an inflation-indexed bond is one which is linked to the rate at which prices increase – or inflation. These products should be particularly popular when inflation is high as it would be a hedge against rising prices and protect the value of the investment.

In India, these bonds were first issued in 1997 under the name of Capital Indexed Bonds. Again, going by the name, these bonds only protected the investor’s initial capital, or investment, from inflation and interest payments were not, with the rate of interest being fixed.

More than a decade later, in 2013, the Reserve Bank of India (RBI) issued inflation-indexed bonds that offered protection from inflation not only to the principal amount but also the interest rate. These bonds, which had a tenure of 10 years, were linked to inflation measured by the Wholesale Price Index (WPI) and the ‘real’ rate of interest they offered was 1.44 per cent on the adjusted principal, which was also linked to WPI inflation. So, when the bond matures after 10 years, its holder would receive the inflation-adjusted principal.
In case inflation ends up falling so much so that that the adjusted principal amount is lower than the face value of the bond, then the face value of the bond would be paid. This keeps a floor on the principal.

What happened to India’s WPI bonds?

As luck would have it, the WPI-linked bonds ended as quickly as it began.
Issued for the first time in June 2013, about Rs 6,500 crore worth of these bonds were snapped in the first few months. However, in January 2014, the RBI announced that it would now base its interest rate decisions to ensure that Consumer Price Index (CPI) inflation was brought down and kept low and stable. This was in response to several years of high inflation that had eroded wealth and savings of Indian households, because of which they had been turning to physical assets such as gold to beat the effect of rising prices.
 

A shift in the RBI’s focus to CPI inflation meant interest rates had to be increased and kept elevated for a period of time. While this helped reduce retail inflation, it also brought down WPI inflation. In fact, wholesale inflation fell from 5.2 per cent in 2013-14 to -3.6 per cent in 2015-16, implying that the inflation-adjusted rate of return would have been less than zero per cent! No wonder demand for these bonds completely dried up and they were even trading at a steep discount in the secondary market.
 

Returns on these bonds were terribly low until the final two years of their life, with WPI inflation rising sharply to 13.0 per cent in 2021-22 and 9.6 per cent in 2022-23 on account of the supply-disruptions caused by the coronavirus pandemic and Russia’s invasion of Ukraine.
 

The future of inflation-indexed bonds

The bad experience of investors with the WPI-linked bonds does not mean these instruments have no future in India. All it might really need is to be linked to CPI inflation, which is what the RBI has been targeting for a decade now.

Interestingly, every time the RBI issues the calendar for the issuance of Indian government bonds, the central bank always says that it can issue instruments different from the vanilla government bonds, including inflation-indexed bonds. However, it is yet to do so.
 

This can change in the future, especially if concerns continue about the impact of high inflation on the Indian saver. Retail inflation has not met the RBI’s medium-term target of 4 per cent in nearly five years. And while headline CPI inflation has declined somewhat after the spikes caused by the pandemic and the war in Europe, food inflation – which is often most important for Indian households – was over 9 per cent in June 2024, as per latest data.
 

In such circumstances, offering an option that can protect investors from inflation can be rather attractive. And while the WPI-linked bonds were primarily snapped up by institutional investors such as banks, mutual funds, and insurance companies, technology has evolved such that bonds linked to CPI inflation can be easily purchased by retail investors through the RBI’s own Retail Direct platform, which is already being used to facilitate the purchase of Indian government bonds and more retail-focused instruments such as the sovereign gold bonds.
 

At the same time, some flexible rate investment options are available in the fixed-income space, including small savings schemes like the National Savings Certificate (NSC), whose interest rates are reviewed every quarter. However, inflation is not a direct factor in deciding the rate of interest on them, and as such, they do not actually offer protection from rising prices.