Inflation is one of the biggest threats to wealth. It can slowly erode the purchasing power of money over time, which is why investors are always on the lookout for instruments that offer protection against inflation. One such instrument is the Inflation-Indexed Bond, also known as the Real Return Bond. In India, inflation-linked bonds were first introduced in 1997 by the government. These bonds are designed to protect the purchasing power of the investor's capital and have become increasingly popular among investors seeking to preserve their wealth from inflation.

 

Inflation-Indexed Bonds are a type of debt security where the face value of the bond rises with inflation and falls with deflation, as measured by an official price index. The real return on the bond is equal to the coupon rate minus the rate of inflation. The interest rate is linked to an index, such as the Consumer Price Index (CPI) and is adjusted intermittently to keep pace with inflation. The bonds are issued by the government with full faith and credit and the purpose of these bonds is to provide a hedge against inflation for investors.

 

The interest payments on these bonds are calculated using the formula that takes into account the current level of deficit finance. The principal amount is typically indexed to inflation. For instance, if the rate of inflation is 3%, and the interest rate on the bond is 5%, then the interest payment would be calculated as 5% of the current principal value, plus 3% of the original principal value.

 

Inflation-Indexed Bonds are an effective way to hedge against inflation. They offer protection against inflation because the payments on these bonds are adjusted according to the rate of inflation, so you will not lose purchasing power over time. Additionally, these bonds tend to be less volatile than other types of investments, so they can provide stability for your portfolio.

 

Investors can purchase inflation-indexed bonds through banks, brokerages, and online platforms. In India, the government offers two options for investors to purchase these bonds- Inflation Indexed National Saving Securities (IINSS)- Cumulative and Index Funds-ETFs. The minimum individual investment is Rs 5000, with a maximum of Rs 10 lakh per year. The maximum institutional investment is Rs 25 lakh per year.

 

Despite the benefits, there are some risks associated with these bonds. Inflation-indexed bonds are generally issued by governments, so they're subject to the same political risks as other government debt. Additionally, these bonds typically have lower interest rates than traditional bonds, so you may not earn as much in interest payments. The Consumer Price Index may not be an accurate measure of the true cost of living as it does not include everything that people buy. Furthermore, these bonds can create phantom income, where the interest payments on the bonds increase due to inflation but the value of the bond does not keep pace with inflation.