Mumbai: Indians are unlikely to soon abandon their fetish for gold and rush into buying bonds indexed to inflation to safeguard their savings from being eroded by the relentless price rise, bankers and bond traders said.
Retail investors will be reluctant to buy the government bonds providing inflation-adjusted returns that finance minister P. Chidambaram proposed in his budget presentation in Parliament on Thursday, since there is no clarity on post-tax returns compared with existing options such as tax-free securities, they said.
Institutional investors also sounded wary because they say it’s difficult to predict where inflation is headed in an emerging market such as India over a time scale of 10-12 years.
Chidambaram’s plan to offer inflation-indexed securities as an alternative to investments in gold preferred by Indian households and a hedge against rising prices has already received approval from the Reserve Bank of India (RBI).
The finance minister seeks to narrow India’s ballooning current account deficit because of growing gold imports. Demand for the yellow metal in India, the world’s largest consumer, has remained undiminished even after the government raised import tax on it in January to 6% from 4% to make investments less attractive. Gold prices have gained for 12 straight years because of demand from investors looking for a store of wealth amid concerns about high inflation.
India had issued similar capital-indexed bonds in 1997, but the plan flopped because only the principal repayments at the time of redemption were indexed to inflation. The interest payments were muted as the coupon rate was not linked to inflation. This time around, though, the principal as well as interest on the bond will be linked to inflation.
Assume, for instance, a Rs.100 bond with a 3% coupon. If annual inflation is pegged at 10%, the face value of the bond will increase to Rs.110, while the coupon payment will also increase to 3.3%, giving the buyer protection against inflation on both principal and interest.
An RBI technical paper on the subject released in December 2010 said the instruments will be of 10-12 years maturity linked to wholesale price indices and aimed at financial institutions such as insurance companies and pension funds.
However, institutional fixed-income traders are awaiting clarity on the structure of these bonds, which will be the first such issue since 1997.
Institutional investors such as banks, government bond primary dealerships, insurance companies and mutual funds are likely to dominate the market in the initial months as retail investors might prove costly to reach and have a host of debt instruments to choose from.
The market is expected to be “purely institutional” as retail investors have other instruments to choose such as tax-free bonds, according to Sandeep Bagla, executive vice-president at ICICI Securities Primary Dealership Ltd (I-Sec).
“There is no evidence of retail participation in India, unless they understand the returns they are getting. There has to be a clear sense on what the post-tax returns are compared to say tax-free bonds,” Bagla said. “Besides, in India, there is no clear visibility on what inflation will be for 10 years. At the most we have a one-year horizon.”
Globally, these bonds have met with success in mostly developed markets such as the UK, the US, France, Canada, Australia and Germany.
The US market for treasury inflation-protected securities has been particularly successful because both investors’ interest payments and the face value of bonds are protected against inflation, unlike traditional bonds.
The American paper has given more than 6% returns in the four calendar years between 2009 and 2012, much higher than the US 10-year treasury bond that is trading at 1.84% currently.
Bagla, however, pointed out that such bonds are difficult to price in emerging countries.
“Those (developed economies) are larger countries with stable inflation. In emerging countries like India where the economy changes in 10 years and inflation could rise sharply because of issues such as supply-side bottlenecks, these bonds will be difficult to price,” Bagla said.
Only Brazil and South Africa among developing countries have sold these bonds so far.
The market for these bonds will have to be created afresh, said Ananth Narayan, regional head, fixed income, currencies and commodities, South Asia, Standard Chartered.
“In the Indian context, we will have to see how it will work, because even RBI has complained about incomplete pass-through of inflation. There are times when the data is not updated or suddenly updated at one go and, most importantly, these bonds will be linked to wholesale prices, which do not reflect retail prices. Even consumer inflation is too skewed towards food,” Narayan said, adding that it will require a “leap of faith from investors” for the market to kick-start.
RBI., nevertheless, is keen to introduce these bonds by May.
“IIBs (inflation-indexed bonds) would increase the menu of choices for savers, and the instrument is particularly attractive to investors who would be able to get assured returns. IIBs are good hedging instruments against inflation. They should encourage household savings to shift away from gold, that is largely unproductive for the economy,” RBI deputy governor Urjit Patel told reporters in a post-budget interaction.
However, traders are not convinced the plan will work.
“In India, where even the interest rate market has not picked up, and banks are mostly buying long-tenure bonds, I am not sure of how this market will develop,” said the head of fixed income of a mutual fund. He spoke on condition of anonymity.
Traders say a rising inflationary cycle will expose the government as both its interest as well as principal outgo will increase.
“In certain cycles, it could be an excellent opportunity for investors. But the market should be liquid enough. I would suggest a five-year tenure because it is not too long term and just enough to take a view on inflation,” said
Vivek Rajpal
, India fixed income strategist at
Nomura Financial Advisory and Securities (India) Pvt. Ltd
.
