Inflation-indexation bonds work in high inflation

Selling them might be tough because of low liquidity. Look at accrual funds for fresh investments from portfolio diversification point of view

Other than interest rate movements, fixed income investments face a threat from inflation, as high inflation means lower returns. This is why investors are always advised to include instruments that can beat inflation over a longer period of time.

Within the fixed income category, inflation indexed bonds (IIBs), that assure a positive return over inflation or mutual funds that invest in these bonds are an option one can look at.

The Reserve Bank of India (RBI) launched IIBs linked to the consumer price index (CPI) in 2013. These bonds give 1.5 per cent plus the inflation rate. But, given that CPI is headed lower (in October it was five per cent), does it make sense to continue with these bonds or funds? According to data from Bloomberg, the coupon on the 1.44 per cent G-Sec 2023, which is the CPI-linked inflation indexed bond, was 3.87 per cent as of August.

Currently, HDFC MF, SBI MF and Deutsche MF offer inflation IIB funds. The one-year returns from them are HDFC-2.04 per cent, SBI-2.43 per cent and Deutsche - 1.75 per cent, according to data from Value Research. Going by the assets under management (AUM) of these funds, they have not been very popular. The AUM, as on October 31, was as follows - HDFC: Rs 1 crore, SBI: Rs 35 crore and Deutsche: Rs 99 crore. These funds are categorised as income funds, where the one-year average return is 8.75 per cent. Is there a case for switching over to income funds or even gilt funds?

IIB funds are not strictly comparable to income funds, because the latter invest in huge universe of bonds, including corporate bonds and government securities, says Vidya Bala, head of mutual funds research, FundsIndia. “While currently inflation is low, we do not know if it will be the same three or four years down the line. One should not invest in IIB funds for wealth creating or generating returns,” she adds.

Navneet Munot, chief investment officer, SBI Mutual Fund also says that IIB funds are work as work as a pure hedge against inflation. “Investors who invest in these funds should come in for a long term. They are looking for a hedge against inflation and over a long term they will get real returns over inflation,” he says.

When interest rates go down, returns from these funds, too, will go up, as in other bond funds. Besides, the negative wholesale price inflation is more due to statistical reasons, he adds.

Liquidity in these bonds is not much, as there is not much trade happening in the secondary market, says N S Venkatesh, executive director - treasury and international banking at IDBI Bank. “Retail participation in the CPI-linked IIBs was good at the time of the launch. Those who are holding their investments are getting good returns because interest rates have fallen since then. Investors will always get real rate of return in these bonds,” he points out.

According to an official from another fund house, which also has IIB funds, it makes sense for investors to be in duration funds because CPI is headed lower. “Going ahead, pressures on inflation such as oil price and subsidies will not have much impact. So, it makes sense for investors to invest in duration funds.”

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