My thoughts on the Technical Paper on Inflation Indexed Bonds (RBI, 9-Dec-2010):
1. Paragraph III.a (Pg 5): “However, unavailability of a single CPI representing the consumption basket of all sections of society in India renders it impractical to be used in indexation of IIBs.” Single CPI is not available in the US. In the US the Consumer Price Index for all Urban Consumers is used in the case of TIPS. Like the US, intra-regional variation in inflation exists in the euzone. Recent inflation indexed issuances have been linked to the eurozone’s Harmonized Index of Consumer Prices (excluding tobacco) in Germany and France. If insurance companies and pension funds are going to be the primary non-speculative users i.e. investors then it may be important to consider that their (insurance and pension funds’) customers would want protection against consumer inflation for their pensions (if they opt for inflation indexed annuities----a product currently not available as insurance/pernsion companies cannot provide it without regular issuances of inflation indexed bonds).
2. Paragraph II (Pg 2):“Going by the past trend of inflation (5.1 per cent) and assuming that real coupon rate emerges to be 2.0 per cent in the auction, the cost of borrowing through IIBs would be 7.1 per cent. The weighted average cost of market borrowings through dated securities during 2009-10 and 2010-11 (up to December 6, 2010) was 7.23 per cent and 7.86 per cent, respectively”
I looked-up the yields of long tenor GSec.
Thus, the weighted average GSec YTM for long tenor bonds from (2002-2010) seems to be barely above the average CPI-IW (All India average) inflation that I had calculated as 7.6% p.a. the period April-1984 to March-2010. I have calculated the CPI-IW (All India monthly average) inflation as 6.1% p.a. for the period 2000-01 to 2009-10. And the CPI-IW (All India monthly
average) inflation for Jun-05 to May-10 as 8.5% p.a. .(Its only at the longest tenor that the issuer may find inflation indexed issuances cheaper than nominal bond issuances.)
3. Paragraph III.b (Pg 7):“The preference of the market participants may vary as per their portfolios and investment needs. Financial institutions such as Insurance Companies, Pension Funds etc. may prefer the IIBs of longer maturity (15 years and above), while banks and mutual funds may like shorter maturity (5 to 10 years). Keeping in view the divergent preferences of market participants, it is proposed to issue IIBs of 10/12 years as it is felt that the instrument would have more demand in this time bucket.” Its only at the longest tenor that the issuer may find inflation indexed issuances cheaper than nominal bond issuances. Besides, Insurance companies and Pension funds have a genuine need for inflation indexed products. And their need would be long-term i.e. in the 25-30 years range. Insurance companies and pension funds can create inflation indexed liabilities. Other entities like banks, Mutual Funds, etc will largely have a speculative interest. This interest can be met my inflation indexed swaps rather than shorter tenor inflation indexed bonds. At least initially the inflation indexed bonds should be issued for tenors of 25 to 30 years.
4. Paragraph III.c (Pg 8): “In the primary auction, the IIB would be issued at par and investors would be asked to quote their bids in terms of real yield. So, the settlement price would be the par value of the bond in the primary auction. During re-issuance or in secondary market, investors can bid in terms of price or real yield.” Like, re-issuances the primary issuance should also be undertaken by a price based auction. Otherwise, with the market will get segmented with outstanding bonds giving wide ranging real yields depending upon the time of their primary issuance. Such market segmentation will hamper liquidity and hinder the development of a real yield term structure. Besides, a price based primary issuance will make it simpler to interpret credit spreads for non-sovereign issuances (utility companies are other suitable candidates for inflation indexed issuances, as their revenues are at times indexed to inflation).
5. There is no discussion on taxation unlike the 24th May 2004 discussion paper on capital indexed bonds. To my mind these bonds should be income tax exempt. Otherwise, very often the real post-tax return would be negative.
