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HOW TO: Hedge Against Inflation

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Inflation indexed bonds, also known as inflation-linked bonds or simply inflation bonds, are financial instruments that protect investors from the effects of inflation. These bonds are designed to provide a return that adjusts with the rate of inflation, ensuring that the real value of the investment is maintained over time.

In India, Inflation indexed bonds were first introduced in 2013 by the Reserve Bank of India (RBI) to provide a hedge against inflation for retail investors. These bonds are issued by the Government of India and are available in both cumulative and non-cumulative forms.

How do Inflation Indexed Bonds work?

Inflation indexed bonds work on the principle of inflation adjustment. The bond’s value is adjusted based on the inflation rate as measured by the Consumer Price Index (CPI). The CPI measures the average price level of goods and services consumed by households and is used as a measure of inflation.

For example, if an investor buys a bond for INR 1000 with a coupon rate of 2% and the inflation rate for the year is 4%, then the bond value will be adjusted to INR 1040 at the end of the year. This means that the investor will receive a return of INR 20 (i.e., 2% of INR 1040) plus the adjusted principal amount of INR 1040.

Advantages of Inflation Indexed Bonds

1. Protection against inflation: Inflation indexed bonds provide protection against inflation as the interest rate is linked to the CPI, which measures the increase in the cost of living.

2. Tax benefits: Interest earned on these bonds is tax-free for retail investors, making them an attractive investment option.

3. Long-term investment: Inflation indexed bonds are ideal for long-term investment as they provide stable and predictable returns over a 10-year period. Moreover, the instruments offer a low-risk investment opportunity, as they are issued by the government.

4. Professional management: Inflation indexed bonds are managed by professional fund managers, who ensure that the investments are made in a diversified portfolio across various sectors.

Disadvantages of Inflation Indexed Bonds

1. Lower interest rates: Inflation indexed bonds offer lower interest rates compared to other fixed income securities, which may not be attractive to investors who are looking for higher returns.

2. Limited liquidity: Inflation indexed bonds are not as liquid as other bonds, making it difficult for investors to sell their holdings if they need to exit the investment before maturity.

3. Currency risk: Inflation indexed bonds are denominated in Indian rupees and are therefore exposed to currency risk if the exchange rate depreciates.

Conclusion

Inflation indexed bonds are a valuable addition to the investment portfolio of retail investors. These bonds provide a hedge against inflation and offer tax benefits. However, investors must assess their risk appetite and investment goals before investing in such instruments. Moreover, it is advisable to consult a financial advisor before investing in inflation indexed bonds to ensure that you make an informed decision.