On inflation bonds, will the govt be third-time lucky?

Investing in inflation-indexed bonds may be a tough call for foreign institutional investors (FIIs), if allowed, as the government makes a third attempt to get the instrument off the ground. While the timing looks right in terms of pricing, lack of market depth may play spoilsport for global moneybags.

Assuming that the bonds are linked to wholesale price index (WPI), that was at 6.84% in February, the real yield – the difference between inflation and the 10-year government bond – may print at 1.1%. “The 1-1.5% level would put Indian rates in line with other high-inflation countries such as Turkey or South Africa,” said Igor Arsenin and Rohit Arora, analysts at Barclays.

But FIIs, who play on real rates, may be attracted to countries like Brazil, Columbia or Mexico that offer higher yields. “Hence, we think Indian bonds, assuming global investors gain access, will be interesting from a portfolio-diversification and total return point of view,” they noted.

Moreover, these investors need to take into account the currency hedging cost that is typically high due to volatility in rupee-dollar exchange rate. From an FII perspective, investments are lucrative if liquid. “India is just starting to issue these bonds. Now, there is neither price discovery nor liquidity,” said Arjun Parthasarathy, editor and owner of the website, investorsareidiots.com. He added that India does not have a real yield curve yet, which makes things more complicated for investors.

At this point, the details are sketchy as the structure for inflation-indexed bonds is still in the works and will be ready by the end of this month. Experts said the benchmark for pricing and steps to ensure liquidity will be the key for the success.

“It could be spread-based bonds with spreads of 50-100 bps over and above the inflation benchmark or with a fixed coupon while par value changeable based on inflation,” said Rajesh Cheruvu, chief investor officer - India, RBS Private Banking. He added that theoretically, the benchmark should be consumer price index or retail inflation, at 10.9% in February, since it has a larger bearing on the overall economy, but it’s most likely to be linked with WPI.

Attaching the bonds with CPI could prove an attractive proposition for FIIs, domestic pension funds as well as individuals and may prevent the fate these bonds met with in 1997 and 2004. However, the government may not be comfortable issuing bonds at 11-12% rate as of now.

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