Bonds in the Indian financial market allow the investor to earn a fixed income with portfolio diversification. Inflation indexed bonds (IIBs) are among these instruments intended to keep investors safe from inflation risk by linking returns to the inflation rate. Retail participants have largely avoided these instruments, despite their innovative structure. Understanding how these bonds are designed, taxed, and practical challenges helps to explain why an investor seldom prefers investing in them, even when using the word “investing” in relation to stability and income.
What Are Inflation-Indexed Bonds?
Inflation Indexed Bonds are securities issued by the government wherein the principal and in some instances the interest payments are related to inflation that is the changes in inflation indices, usually the Consumer Price Index (CPI). The purpose of these types of bonds is to safeguard the purchasing power of the investing public even when inflation causes currency depreciation.
Take inflation for instance; if it increases, the IIB’s notional principal also increases, which will trigger the upward adjustment of the coupon payment. This makes IIBs, in theory, an inflation hedge and a savings instrument for the long term.
Why Were They Brought One into India?
Through inflation indexed bonds, the Indian government provided protection to savers against inflation while also promoting financial inclusion in the debt market. The long-term investment of these instruments was also intended to reduce dependence on traditional savings products. The idea was to have households and institutions invest in bonds with real returns after adjustment for inflation.
But as of now, their take-off has been rather slow. Retail and institutional investors still seem to turn to traditional government securities, corporate bonds, or deposits rather than these specially designed instruments.
Main Reasons for Limited Appeal
1. Complex Structure
Its mechanism to adjust the peers and interest with inflation does not make sense. Compared to other, more straightforward avenues for investment in bonds, IIBs seem complicated, making retail participation in IIBs a limited option.
2. Low Liquidity
One of its main concerns is that there is no active secondary market for impaired inflation indexed bonds in India. Investors can’t get out of their bonds until maturity, which will attract quite a few investors who prefer liquidity.
3. Tax Treatment
Though the inflation-adjusted princi-pal protects realistic valuation, the taxation on that adjustment of principal is disadvantageous. Inflation will increase the value of the principal, which is taxed as income, although the money isn’t received until maturity. Thus, the tax burden with IIBs is higher than other forms of bond investment in India.
4. Better Options in the Practical World
There are always simpler products available to investors, such as government bonds, corporate bonds, or fixed deposits, which are simply easier to work with even without the advantages of inflation insurance. That predictability and accessibility outweigh most of the theoretical advantages that IIBs offer.
Implications for a Long-term Investor
In principle, IIBs protect investors who wish to invest in bonds in the future against inflation. However, the taxation issue diminishes the attractiveness of IIBs as a long-term wealth generation instrument. In practice, low liquidity also discourages that flexibility for any investor who might demand it from their portfolios.
Worse, the same tumor-structural and taxation-induced aversions make it difficult for institutional investors to use such products in their portfolios. Demand thus continues to languish.
The Road Ahead
There are quite a few things to change with respect to acceptance of inflation-indexed bonds in India. Market liquidity improvements, investor education, and tax reforms can do wonders to make them more attractive for the investor’s need. Until then, most of the market players who prefer to invest in bonds will continue to rely on old options that offer more predictability and easier management.
Conclusion
Inflation indexed bonds were intended to keep investors safe from inflation and promote long-term savings in debt markets. However, their complex structure, tax inefficiency, and low liquidity inhibit their attractiveness. They theoretically protect purchasing power, but in practice, they are much less utilized than other bonds in India. Even regarding investments in bonds, most investors will favor simpler, more liquid options instead. Thus, IIBs remain a niche product that fails to attract significant participation.
