Consumer Inflation-Linked Bonds

The new IINSS looks set to deliver much better tax adjusted returns than FDs.

What is the catch? Is there a catch?

The Reserve Bank of India has inched closer to fulfilling the promise that new Governor Raghuram Rajan made in his first statement two months ago, bringing savers one step close to having access to what looks like best deposit that they will be able to find. The central bank has announced details of a deposit whose interest rate is linked to the consumer inflation in India. The bank has said that this new instrument, called the Inflation Indexed National Savings Securities (IINSS), will offer an interest rate of 1.5 per cent per annum (paid every six months) while the principal amount--on which the interest is paid--will keep rising up every month in step with inflation.

 The IINSS is meant for retail investors, there being a limit of Rs 5 lakh per applicant. According to the RBI, the IINSS will be based on the 'final combined CPI' with a three month lag. For example, the provisional combined (meaning rural and urban) inflation rate was 10.09 per cent p.a. If the final rate is also the same, then in January--which is a three month lag from October--the principal amount of Rs 10,000 invested in IINSS will rise to Rs 10,080.47. This is an increase of 0.08047 per cent, which if compounded over 12 months.

If the inflation rate were to sustain at this level, then after one year the saver would have total gains of 11.5 per cent. This high return, with a government guarantee, sounds phenomenal and it is. However, the real icing on the cake is the tax-efficiency of these deposits. As the RBI's statement makes clear, the inflation-adjustment of the principal is capital gains. On adjustment with the cost-inflation index, they will essentially disappear and thus be effectively tax-free. Only the 1.5 per cent of interest income will be taxable. Even if inflation drops, bank FDs and other deposits will likely keep pace. The IINSS is likely to become the first choice of any smart saver, to the extent of its per-applicant limit.

In fact, so good a deal is the IINSS, that I can't help suspecting that there will be some catch. After all, a large part of the advantage of these bond comes from a lower tax outgo. Given the government's dire fiscal situation, I would be disappointed but not too surprised if the tax authorities bowl a googly at investors. Let's keep our fingers crossed.

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