1. The government can reduce the coupon rates on its borrowing by way of IIBs.
2. IIBs provide protection to 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
Ans: a
Explanation:
Inflation-Indexed Bonds
Inflation-Indexed Bonds, also known as inflation Bonds, are a type of government-issued security designed to protect investors from inflation, these bonds adjust their principal value and interest payments based on the inflation rate, as measured by Consumer Price index (CPI).
If Inflation Bonds are purchased , the principal amount is adjusted periodically based on the changes in CPI i.e if inflation rises, the bond’s principal increases, and if inflation falls, the principal decreases. As aresult , the interest payments, which are calculated as a percentage of the adjusted principal, also vary with inflation.
Example of working IIBs:
Suppose an investor purchases an IIB with a face value of Rs. 1,00,000, a ten-year maturity, and a Coupon rate of 3% above inflation.
If the inflation rate is 4% when the bond is issues, the investor will receive an annual interest payment of Rs. 3120 (3% of INR 1,04,000) in the first year instead of Rs.3000
If the inflation rate increases to 5% in the second year, the investor will receive an annual interest payment of Rs. 3276. 0 (3% of INR 1,09,200) in the second year.
The Coupon rate will remain at 3% above inflation throughout the ten-year tenure.
IIBs will provide inflation protection to both principal and interest payments.
- Capital protection will be provided by paying higher of the adjusted principal and face value (FV) at redemption. If adjusted principal goes below FV due to deflation, the FV would be paid at redemption and thus, capital will get protected.
- Interest rate will be provided protection against inflation by paying fixed coupon rate on the principal adjusted against inflation.
Hence statement 2 is correct.
Taxation provisions:
Extant tax provisions will be applicable on interest payment and capital gains on IIBs. There will be no special tax treatment for these bonds.
Hence statement 3 is incorrect.
| Since IIBs would be Government securities (G-Sec) The different classes of investors eligible to invest in G-Secs would also be eligible to invest in IIBs.They can be tradable in the secondary market like other G-Secs.Would be eligible for short-sale and repo transactions.IIBs would automatically get SLR status. |
Like other G-Secs, coupon on IIBs would be paid on half yearly basis. Fixed coupon rate would be paid on the adjusted principal.
Indexed bonds could reduce government borrowing costs: If the market overestimates future inflation, government will reduce borrowing costs by issuing indexed bonds rather than nominal bonds. This may occur because government is able to influence inflation through its policies, may have better information about the future course of inflation, or perhaps has more faith in its commitment to contain it than the public does. In these cases the government can lower its costs by issuing indexed bonds as the nominal interest rate (i) is the sum of the real rate (r) and expected inflation (p).
Hence statement 1 is correct.
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