UPSC Prelims 2022 Q5: Inflation-Indexed Bonds (IIBs) — Explained
With reference to the Indian 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. IIBs 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?
- 1 and 2 only
- 2 and 3 only
- 1 and 3 only
- 1, 2 and 3
Answer: (a) 1 and 2 only
Statement-wise explanation
- 1: correct — An IIB pays a fixed real coupon on a principal that rises with inflation, so the coupon rate printed on the bond is much lower than on an ordinary bond. India's 2013 IIB carried a coupon of just 1.44% ('1.44% Inflation Indexed Government Stock 2023'), well below the nominal yield on 10-year G-secs at the time. RBI's 2010 technical paper on IIBs says the government pays a lower yield because investors no longer demand an 'uncertainty premium' for inflation risk. It also says coupon outgo falls when inflation falls.
- 2: correct — This is the defining feature of an IIB. In India's 2013 IIBs, the principal was adjusted by an index ratio based on WPI, and the fixed coupon was paid on that adjusted principal, so both principal and interest kept pace with inflation. At redemption the investor gets the adjusted principal or the face value, whichever is higher, so deflation cannot cut the repayment below par. The earlier Capital Indexed Bonds of 1997 had protected only the principal.
- 3: incorrect — RBI's 2013 FAQ on IIBs says the existing tax rules apply to both the interest and any capital gains arising from the inflation adjustment. IIBs got no special tax exemption. They were taxed like any other government security.
How to eliminate
Statement 2 is just the definition of an inflation-indexed bond, so it must be in the answer. That leaves only the options pairing 2 with 1 or with 3. Statement 3 makes a sweeping claim: both interest and capital gains are tax-free. Interest on government securities in India is normally taxable, and very few instruments get a full exemption on both interest and gains. A claim that strong should make you doubt it unless you know of a specific exemption, and IIBs had none. Statement 1 can be worked out from first principles. If the investor is protected from inflation, they no longer need a nominal coupon padded with an inflation premium, so the government can offer a lower (real) coupon. The fact to remember: IIBs have a low real coupon (1.44% in 2013) and are taxed like ordinary G-secs.
Know more
What an IIB is. An Inflation-Indexed Bond links its principal (and therefore its interest) to a price index. The coupon is fixed in real terms. The inflation uplift is added to the principal, not paid out as extra cash each period.
India's history
| Instrument | Year | Index | What is protected |
|---|---|---|---|
| Capital Indexed Bonds | 1997 | WPI | Principal only |
| Inflation Indexed Bonds (1.44% GS 2023) | June 2013 | WPI (final, 4-month lag) | Principal and coupon |
| Inflation Indexed National Savings Securities–Cumulative (retail) | Dec 2013 | CPI (2010=100) | Fixed 1.5% + CPI inflation, compounded half-yearly and paid at maturity |
How the payout works
- Index ratio = reference index on the payment date ÷ reference index on the issue date.
- Adjusted principal = face value × index ratio.
- Coupon = real coupon rate × adjusted principal (half-yearly).
- At maturity: adjusted principal or face value, whichever is higher (a deflation floor).
Who gains what
- Government: lower coupon, because there is no inflation-risk premium. It also has a reason to keep inflation low, since higher inflation raises its own repayments. The risk is that actual inflation may exceed what the market expected, which makes borrowing costlier.
- Investors: a known real return and a hedge for pensions and insurance funds. IIBs also give households an option other than gold.
Why they faded in India. The 2013 issues drew weak demand: the product was complex, retail participation was low and the secondary market was thin. They were linked to WPI while retail savers felt CPI inflation, which also hurt.
Tax. IIBs got no special treatment. Interest and indexation gains fall under normal income-tax rules.
In the news
Retail inflation in India rose above RBI's 6% upper tolerance limit in early 2022, and protecting savers and borrowers from inflation was widely discussed. The 2013 IIB (1.44% GS 2023) was also due to mature in June 2023.
NCERT Concepts to Revise
- Inflation-indexed bond: The whole question tests the defining features and limits of an inflation-indexed bond.
- Coupon rate: Statement 1 depends on what happens to the coupon rate the government must offer on an IIB.
- Real interest rate: An IIB's coupon is fixed in real terms, so the real interest rate is the key to Statement 1.
- Government securities: Indian IIBs are government securities, and Statement 3 turns on how G-sec income is taxed.