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UPSC Prelims 2022

Inflation Indexed Bonds - UPSC Prelims 2022 Question

Prelims General Studies Paper - 1

Jan 10, 2023

2 min read

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Question

 

With reference to the India economy, what are the advantages of “Inflation-Indexed Bonds (IIBs)”? 

 

1. Government can reduce the coupon rates on its borrowing by way of IIBs. 

2. IIGs provide protection to the investors from uncertainty regarding inflation. 

3. The interest received as well as capital gains on IIBs are not taxable. 

 

Which of the statements given above are correct?

 

A. 1 and 2 only

B. 2 and 3 only

C. 1 and 3 only

D. 1, 2 and 3

 

Answer

 

The correct answer is A. 1 and 2 only.

 

1. Government can reduce the coupon rates on its borrowing by way of IIBs. By issuing bonds that are indexed to inflation, the government can reduce its borrowing costs and the coupon payments it needs to make to bondholders because the principal and interest on these bonds are adjusted for inflation. This means that if inflation rises, the government pays more interest on the bonds but also receives more on principal repayment. This can help to reduce the overall cost of borrowing for the government.

 

2. IIBs provide protection to the investors from uncertainty regarding inflation. These bonds protect the bondholder from inflation risk, which is the risk that the purchasing power of the interest and principal payments will be eroded over time by inflation. This is because the interest and principal payments on these bonds are adjusted for inflation, which means that the real value of the payments will remain constant over time. This can help to protect the bondholder's purchasing power and provide a hedge against inflation.

 

3. The interest received as well as capital gains on IIBs are not taxable, this is not true. The interest received on these bonds and capital gain on sale of these bonds are taxable.

 

IIBs are similar to the conventional bonds, but the return on these bonds are adjusted based on the inflation rate, thereby providing protection to the investor from inflation.

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