Inflation linked bond funds have limited utility

Suitable only for conservative investors; other debt funds give better returns now

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Wouldn’t you want to protect your investments from inflation? Earlier, investing in gold was the only option. The Reserve Bank of India then launched Inflation Indexed Bonds (IIBs) as a hedge against inflation. But these did not see a good response from investors due to the high taxation (the interest is taxed as per your income bracket) and because they were not marketed properly.

So, does it make sense to invest in bond funds that are benchmarked to IIBs? Only if you are an extremely conservative investor, say experts.

The latest IIB Fund is from SBI Mutual Fund, which is an open-ended debt fund and closes for subscription on October 31. The fund will invest 70-100 per cent in inflation-indexed securities and up to 30 per cent in debt and money market instruments and units of debt and liquid mutual funds. Other fund houses offering similar funds are HDFC MF, which launched its IIB bond fund in March 2013 and Deutsche MF, which launched its IIB bond fund January.

Theoretically, IIBs are supposed to provide relatively consistent real returns by indexing both the principal and coupon payments for inflation. But in a scenario when inflation is likely to go down, the returns from these bonds will be lower than other debt funds, says Hemant Rustagi, CEO of Wiseinvest Advisors.

"To begin with IIBs have not been popular because they do not take care of taxation. However, IIB funds may give some tax efficiency since you can get long-term capital gains exemption after three years. But then again, if you have to remain invested for that long, today there are several other options like income, gilt, or arbitrage funds. Inflation indexed bond funds have limited utility,'' Rustagi points out.

The Wholesale Price Index (WPI)-based inflation dropped to 2.38 per cent in September, the lowest since October 2009 (1.78 per cent). Currently, the secondary market for IIBs are illiquid and primary issuances are not coming. In fact, in the current financial year, RBI has not auctioned these bonds as the response last year was not so positive, say experts.

Only conservative investors with a time horizon of five years or more should take an exposure to IIB funds, says Renu Pothen, research head, iFAST Financial, a mutual fund distribution platform.

“Investors whose holding period is between one and two years can look at investing into income funds or gilt funds. As interest rates are expected to come down in the next few months, these categories of funds (income/gilt) will generate returns which will beat inflation,” she says.  Investors who are in the lowest tax-bracket and want no risk on their portfolio can consider IIB funds, Rustagi says.

"Suppose you invest in gilt funds and the decline in interest rates does not happen as expected by markets, then there is a possibility that your investments can become volatile and you may lose capital. But the fact is these funds are now seeing good returns, though there is a risk. So, investors who don't want to take on any risk at all, can look at IIB funds,'' he adds.

According to an official from a mutual fund, the aim behind this fund is not capital appreciation, but only to hedge inflation. So, while the fund may not see much demand in the current market, it may be suitable for investors who are planning to invest in gold in order to beat inflation. "Investing in such a fund may have been a better option two years back, more than now,'' he admits.