Inflation Indexed Bonds an Introduction to C Linkers and P linkers
Introduction
Bonds are securities that pay a fixed coupon every 6 months (generally), as we have seen in
time value of money the value of 100 Rs. today is valuable more than 100 Rs a year later.
Theoretically, the reason for this preference is the opportunity cost of capital, in real life
however the reason is due to inflation. Inflation is the gradual erosion of purchasing power
due to the increase in prices of goods (faster than income growth).
The fixed income securities market is mostly used by people who have a big corpus and want
to retire, the age demographic of the fixed income security market is increasing. This increase
is caused by an increase in the average age of a person in many countries(Japan, USA and so
on). Based on statistical data we can say that older people tend to prioritize on cash flow
creation and capital preservation over growth.
Inflation erodes capital, FD rates in India have almost always overlapped with inflation,
therefore the purchasing power of the people who are reliant on it keeps increasing. To solve
this issue inflation indexed bonds were introduced. Instead of having fixed coupons these
bonds pay coupons which are indexed to CPI (Consumer Price Index) or RPI (Retail Price
Index) or any measure that captures the general increase in goods and services.
The index assumes a particular year to be the base year and states the cost of goods and
services as against the base year. This process gives us what is called an indexation factor.
Say, the base value of CPI is 100 and the current value of CPI is 107 then the indexation
factor is 107/100 = 1.07. Let us assume we are supposed to receive a cash flow of 30 Rs the
we receive 30x1.07= 32.1 Rs.
What is in it for the issuers?
The issuers of t
History of Inflation Linked Bonds (ILB’s)
One of the first records on inflation indexed bonds tells us that inflation indexed bonds were
first issued by the Common Wealth of Massachusetts in 1780 the revolutionary war. UK was
one of the first developed markets to issue linkers in its money markets closely followed by
many other developed markets. Currently TIPS (Treasury Inflation Protected securities is the
largest component of the global market.
The Indian market had its first inflation indexed security launched in 1997, they were issued
in the name of CIB (Capital Indexed Bonds). The Indian Inflation linked bonds market is still
nascent and there are talks about the RBI gouging investor demand for inflation indexed
bonds.
Types of Inflation Indexed Bonds
There are two types of inflation indexed bonds Capital Indexed Bonds (CIBs) and Indexed
Annuity Bonds (IABs).
Capital indexed bonds are those bonds whose capital value and interest payments are
adjusted periodically with respect to change in CPI, RPI or whatever metric it is indexed to
i.e., the coupon rate remains the same but the capital keeps getting readjusted, this causes the
coupon payment in rupees to increase or decrease with respect to the money market. This
type of bonds is called P linkers (P refers to the principal of the bond being adjusted).
Annuity indexed bonds are those bonds whose capital value and interest payments remain the
same but the coupon rate keeps changing. The coupon rate is indexed to CPI or RPI or any
other metric of purchasing power. This type of bond is called a C linker (C refers to the
coupon value being adjusted).
Pros and Cons of Inflation Indexed Bonds
The pros are as follows: 1. The bonds have a fixed long-term yield i.e., the owners of the security will have her
or his purchasing power grow at a constant rate irrespective of inflation rates. These
bonds are especially relevant for an emerging economy like India where the FD rates
hardly keep up with the inflation rate.
2. Inflation indexed bonds are completely uncorrelated with the stock markets, therefore
they can provide diversification benefits to investors. They provide a hedge against
inflation and against other economic downturns where the market does not perform.
The cons are as follows: 1. Inflation indexed bonds have a deflation risk i.e., in a period of low inflation, inflation
linked securities perform poorly as against the market. The real rate of return given by
an inflation indexed bond is constant which implies that for any inflation rate R the
return is R + k. ‘k’ here is a constant rate at which the security beats inflation.
Return R + k is directly dependant on the R which is the inflation.
2. CPI is the most common measure of inflation in India however it is not a perfect
measure of inflation. It does not consider the fact that different households have
different spending patterns i.e., for a vegetarian upper middle-class family the
demand for meat would be zero while it would be very high for a non-vegetarian
family of the same economic strata.
3. Inflation indexed bonds in India do not have any tax sops (no tax incentives)
4. The per person investing range is Rs 10,000- Rs 2,00,00,000. When the capital is
small the amount that gets lost by inflation is very small, the cap of Rs
2,00,00,000 must be increased or removed so that more money can be protected
from inflation.
C linkers vs P linkers (how to choose)
If the investor prioritises the value of the capital invested over a regular cashflow a P
linker is preferred as it keeps updating the value of capital according to inflation and then
pays a coupon rate on it. One might wonder if capital gains tax will apply, the answer is
yes. If you think that since the capital and capital gains tax are indexed and both of them
will mitigate each other you are right. Capital gains tax is indexed to the cost inflation
index while capital indexed bonds are indexed to the WPI (wholesale price index) as a
result the investor will be taxed on a figure based on the discrepancy between these two
indices.
An investor who prioritises cashflow over capital would buy a C linker as this would keep
the invested amount constant and keep giving investors a cashflow that keeps their
purchasing power constant. C linkers do not have any capital gains as the value of the
capital does not appreciate in fact by cost inflation index it would have a tax redemption.
We cannot be sure on the tax redemption part as RBI has not issued any C linkers.
Interesting questions
Should CPI or WPI be used as an index for Inflation indexed bonds?
Both the CPI and the WPI are imperfect indicators of inflation in the economy as a result
it is important to find out which one is more accurate or relevant. In the case of India RBI
states that they will be using WPI, the reason for the same is that the consumers tastes and
preferences keep changing therefore making the CPI unstable. The change in
consumption is very transient in the Indian economy due to its rapidly developing
economy. In order to maintain price stability, it has decided to use WPI for measuring
Inflation for inflation indexed bonds.
What would happen if halfway through the maturity of the WPI changes?
It would be a big mess if there were two time periods with two different base periods to
which each cashflow will be incremented (assuming there is no deflation). There is a
revision of WPI base rates every 10 years and if the security has a maturity of 10 years or
is purchased such that its purchase date falls in one time period and the sale date falls in
another time period (each time period being 10 years), then the index in spliced and a
unanimous base rate that is created. This base rate is used to find the returns.
Most securities are purchased/ priced through competitive bidding, what does the
government do to ensure that people of lower economic strata can also access the market?
The government ensures that 5 percent of the auction is reserved for non-competitive
where the government sets a price for people to buy. To access this however, one must
have to open a gilt account or a demat account with the banks or the PD’s (primary
dealers).
Conclusion
Inflation Adjusted bonds as a security has been slow on the uptake but are constantly
gaining the attention of investors. The market for inflation indexed securities in the world
is booming and many more financial products are being engineered towards the creation
of securities that work against inflation while providing investors with good returns.
Note of Acknowledgement
This essay on C linkers and P linkers would not have been possible without the expert
guidance and infinite patience of Dr. Parameswaran. The lessons he has taught to me in
this semester has moulded my perspectives and helped me shape my perspectives and
analysis of the fixed income market.
Sources and Data
RBI Frequently asked questions
https://m.rbi.org.in/Scripts/FAQView.aspx?Id=91#:~:text=Inflation%20Indexed%20Bonds%
20(IIBs)%20were,and%20not%20to%20interest%20payment.
Chen James| Index-linked bond definition | Investopedia
https://www.investopedia.com/terms/i/indexlinkedbond.asp
Rupp Heather| The Demographic Impact on the Fixed Income Market |Peritus Assets
https://www.peritusasset.com/2017/05/the-demographic-impact-on-the-fixed-incomemarket/
Bessembinder Hendrik, Spatt Chester, Venkataraman Kumar | A Survey of the Microstructure
of Fixed-Income Markets | Journal of Financial and Quantitative Analysis
India Inflation rate 1960-2022
https://www.macrotrends.net/countries/IND/india/inflation-ratecpi#:~:text=India%20inflation%20rate%20for%202021,a%200.61%25%20increase%20from
%202017.
Domestic term deposits interest rates for 10 years
https://sbi.co.in/web/interest-rates/interest-rates/deposit-rates
Segal Troy | Hedge Your Bets with Inflation- Indexed Bonds | Investopedia
https://www.investopedia.com/articles/bonds/09/inflation-linked-bonds.asp
Two types of inflation linked bonds
https://thewire.fiig.com.au/article/education/education%20(basics)/2014/09/09/two-types-ofinflation-linkedbonds#:~:text=Simple%20explanations%20and%20useful%20strategies,indexed%20annuity
%20bonds%20(IABs).
RBA (Reserve Bank of Australia)
https://www.rba.gov.au/education/resources/explainers/inflation-and-itsmeasurement.html#:~:text=It%20does%20not%20measure%20price,a%20certain%20items%
20than%20others.
Forbes Advisor
https://www.forbes.com/advisor/in/investing/inflation-indexed-bonds/
Pimco Global
https://global.pimco.com/en-gbl/resources/education/understanding-inflation-linkedbonds#:~:text=The%20earliest%20recorded%20inflation%2Dindexed,%E2%80%9Clinkers
%E2%80%9D%20to%20the%20market.
Curve Securities
https://curvesecurities.com.au/capitalindexedbonds/
Business Line
https://www.thehindubusinessline.com/money-and-banking/no-special-tax-sops-for-inflationindexed-bonds/article64102904.ece
The Wire
https://thewire.fiig.com.au/article/2015/09/21/two-types-of-ILBs
Income tax department India
https://incometaxindia.gov.in/charts%20%20tables/cost-inflation-index.htm