Inflation Indexed Securities: Buy if at Lower Tax Slabs

8 comments Written on December 22nd, 2013 by
Categories: Bonds, Concepts, Demystify, Gilts, Inflation, RBI
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Yes, you can now buy Inflation Protected Securities. RBI has announced that these bonds will be available for purchase between Dec 23 and Dec 31, 2013.

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What are Inflation Protected Securities?

At the risk of repeating myself:

  • Government issued bonds that pay interest based on Consumer Price Inflation +1.5%
  • Rs. 5,000 minimum - that’s 50 bonds at Rs. 100 per bond.
  • A maximum of Rs. 500,000 per applicant per annum.
  • Interest isn’t paid out, it’s compounded and a lumpsum paid after 10 years.
  • You can buy from a SBI, SHCIL, HDFC Bank, ICICI Bank and Axis bank, between December 23 and 31.
  • Taxable: Interest is taxable as income, like a fixed deposit. You have to declare it and pay tax on it even if it is compounded.
  • No Selling: The bond stays in your name till you die. You can nominate anyone else to get it after you die, including NRIs. They don’t get the money, they have to hold the bond till it matures. 
  • Only for individuals, HUFs and charitable trusts. NRIs cannot buy. No corporates or financial institutions can buy.
Interest Rate Calculation

You get inflation plus 1.5% per year. How do they calculate inflation?

imageInflation is based on the Consumer Price Index released by MOSPI.

When you buy the bond, your base inflation index is the one 3 months earlier. Every six months, interest is calculated as:

Interest = (Percent change in Inflation Index from 6 months earlier) + 0.75%.

On the left, you will find the CPI Index for various months as released by MOSPI. You can find new data on Capital Mind every month.

Assume you invested in such a product in December 2012. The index is marked to three months earlier, Sep 2012 (124). The first coupon payment is six months later, in June 2013.

To calculate how much to pay in June 2013, we take the index valid three months earlier, so March 2013 (127.5).

Inflation rate for six months: (127.5 / 124 -1) = 2.82%.

Interest paid out = Inflation + 0.75% (since 1.5% is per year). = 3.57%.

This interest is added to the principal (the concept of compounding).

The second coupon would be due in December 2013, when we use the index of Sep 2013 (136.2).

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We can see here that in the last one year, you have got an effective return of Rs. 11,417 on the Rs. 100,000 invested, which is 11.4%. CPI inflation is running around 10%, so this return is actually about inflation plus 1.5%.

The interest payout has a lower floor of 1.5%. Which means, even if inflation is negative, you will get a 1.5% return minimum.

Read the full FAQ, which contains two examples.

Risks
  • Credit Risk: Very low. (it’s the government, silly!)
  • Market Risk: You can’t sell the securities, so what market?
  • Reinvestment Risk: Automatically compounded; so you don’t have to worry about finding other avenues for reinvestment.
  • Interest rate risk: Yes, big. Bank FD rates today are less than CPI+1.5% but you never know when that can change. Inflation could fall, or interest rates could rise. There is a risk that you could have done better with a fixed deposit or such.

The biggest risk is that interest rates offered by alternate products will yield higher returns. You must consider factors like taxes and liquidity to assess other forms of risk.

Pre-payment Penalty and Restrictions

You will be able to redeem early if you’re 65+ after 1 year. For others, you have to wait for 3 years.

You can only redeem “a few days” before the coupon dates. These will be once every six months. You will have to approach one of the banks (SBI, Axis, HDFC, ICICI) or SHCIL for that.

The prepayment penalty is half the last coupon paid. Meaning - if they have to pay you Rs. 1,000 for the half yearly interest, they’ll pay you just Rs. 500.

For the example above, if you redeemed after one year, you would pay half of the 7.57% half-yearly return, or 3.79%, as the penalty. (Translates to Rs. 3922, due to the compounding).

When Inflation is very high, the prepayment penalty is huge.

Liquidity: Can’t Sell It - There’s No Market. But Can Get Loan

If you can’t redeem it, can you sell it? No.

The “transferability” clause states that the bonds can only be transferred in one condition: to a nominee after death.

Even though Non Resident Indians can’t buy, they can be nominees.

But you can borrow against this as a security. Which is good for an ultra-desperate situation, as against early redemption and a penalty.

Taxes: Interest only at Maturity But Pay Tax Every Year

These are not tax free bonds. Therefore, the interest is taxable. Like a “National Savings Certificate”, you must declare the interest every year as income and pay tax on it. Even if you aren’t even getting the money in your pocket.

These bonds also don’t currently apply for tax savings under the 80C bracket. We might see that happen next year, I hope, but let’s not count on it.

Alternatives

There are tax free bonds from the likes of NTPC which offer 8.66% (tax free) on the 10 year term, with the ability to sell early in the markets. PPF also offers 8.7% tax free interest.

There are liquid funds and Fixed Maturity Plans yielding 9% post tax if you hold for a year or more. But this is not guaranteed over 10 years.

My analysis

Here’s how CPI data has been. We have data only since Jan 2011.

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CPI inflation is mainly food (49% weight) and food inflation has been 14.5% recently. If prices are looked at recently, we find that food prices have fallen substantially.

That means CPI might not increase at the rapid pace it has done recently. Food contributed 7.3% of inflation in November (of the inflation of 11.2%). Even if the rest of the items stayed where they are, and food inflation fell substantially, you can see CPI inflation at 7% next year.

This is a pre-tax return of 8.5% which compares weakly with other products where the lower taxes make them more attractive. (Tax free bonds, FMPs, liquid funds)

However there are good reasons why food inflation might continue to go up in the next 10 years and keep CPI high:

  • Food Security Bill related purchased by the government, which keep procurement high and thus, supply low.
  • Higher minimum prices of government buying.
  • Election year will make the government do populist things with food, meaning high food inflation.
  • Food in general has become higher in demand as more people get out of poverty. Supply isn’t growing by that much.
  • Better warehousing and cold storage which allows farmers to keep out food items when prices are low (hoarding).

You have to take your call. And then, there are the issues of lack of liquidity and taxes.

For someone in the 30% tax bracket, even an interest of 11.5% means less than 8.5% after tax. The attractiveness of this product therefore depends on your earning potential, and the fact that you can only invest Rs. 500,000 maximum makes it more attractive for middle-class savings (tax rates of 20% or lower).

I spoke with Manish Chauhan of Jagoinvestor, who has a splendid post on the topic. He says:

I see them as excellent alternate to traditional insurance products. Given Indians are crazy about Traditional insurance because of 'security' and 'guarantee' . These bonds can be a great alternative for those investors , because these bonds atleast protects from your inflation, though taxable, still its one of the things one can invest in for some part of their portfolio.
 
Given taxation angle, For those who are in lower tax bracket, its a good place to invest for their long term goals like Children Education or Corpus creation if one is too scared with inflation (and they should be)
Will I Buy?

Very likely, for part of my children’s bond portfolio where I don’t need the cash flow, as an HUF which has low income so I get taxed at a lower rate. The only pain point is the lack of liquidity.

It could be good for senior citizens (60+) who need to ensure that their money is kept away from slimy bankers, and who want an annuity at a much better rate than anything else available currently. But even for them, the lack of interest rate being paid out is a concern.

The product makes sense for anyone in income brackets that are less than 30%, but you have to buy the idea that inflation will remain fairly high over the next few years. If CPI inflation falls, your return comes down appropriately. (In which case the fixed coupon tax-free bonds or PPF is a way better idea).

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About the Author:
http://www.capitalmind.in
The man behind Capital Mind. Deepak is a co-founder at MarketVision, a financial knowledge company. Deepak also provides data research and consulting services, and now lives in Bangalore. Connect with him at deepakshenoy@gmail.com.

8 comments “Inflation Indexed Securities: Buy if at Lower Tax Slabs”

Very Informative Article.

strange! why to declare income from interest when it is just accumulating?
That year its not my income!

Same with longer term FDs – they also have to have tax deducted even if they are compounded interest.

Deepak,

Very informative article. In my view, this product could have replaced the PPF if the corpus was NOT taxed at the redemption stage. As for your view on suitability of this product for people at lower tax slabs an individual who is currently at 20% tax slab would most likely move to 30% in 10 yrs(at redemption), in which case the returns would almost mirror post tax FD returns, unless inflation remains at 12-14% for the major part of the 10 yr period.

I would still go with a PPF a/c for the kids bond portfolio, and allocate funds to these bonds, if i have >INR 1L to invest.

But this product makes great sense for people who are retired OR/AND are senior citizens, from taxation and early redemption window perspective.

What do you think?

The prepayment penalty is pretty high. HOwever I know what you mean about the 30% slabs. I am thinking of buying some in an HUF where tax is low. Let’s see how that works…

Clear cut article Deepak. Thank you.
Best thing about these bonds are that risk-free and inflation adjusted.
May be in days to come, you will apply Fisher equation and analyze further.

nice article ///the problem here is if say there is a deflation in the world and rates rise to deflation …say double .what happens ? u cant move money like FD.it is not liquid.
why come out with this product ?

COz govt knows either gold demand is going explode or they are trying to locking in rates coz they know they cant control rates which are going to rise all over the world .

will make sense only if rates spike to buy some but not worth it .precious metals better bet coz it directly checks in MONEY SUPPLY = INFLATIOn

Hi Deepak

I have been reading your blogs since 4-5 years and after a long time , I see analysis article without hint of sarcasm.

Keep it up.


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