Inflation Bonds, Dearness Allowance (DA) for Investors
Good beginning but lot more needs to be done
Middle class who had been battling inflation for last so many years has been offered a chance to hope for a stream of some secured real income by way of interest on their hard earned savings at a rate that will increase with increases in levels of inflation. Though a lot of improvement need to be made in the scheme that is going to remain open for investment till March 14, a good beginning is made through a social security measure designed for middle and lower middle class.
Consider a case of a person who has opted for VRS five years ago at the age of 50 by accepting a lump sum compensation of say Rs. 18 Lakh. At 10% FD rate of interest, monthly interest of Rs. 15000 could have been thought by him as sufficient income to support his family expenses. However with inflation rate of 10% pa. anybody can imagine how much of his monthly expenses can be met today at same income of Rs. 15000 considering prices of necessities at current levels. Purchasing power of his Rs. 15000 received per month 5 years ago is now reduced to half leaving real income of just Rs. 7500 per month at prices obtaining 5 years ago when he retired and invested his lifetime earnings. Like him thousands of fixed income earners and self employed people from middle class and lower middleclass have always dreamed for some savings scheme which will provide them some real interest which will remain unaffected by loss of purchasing power caused due to inflation. Importance of such a scheme for retired persons having fixed savings can hardly be overemphasized from social security point of view.
In the absence of such a social security measure, Indians have learnt to bank upon gold as the only available hedge against inflation. This urge for investment in gold from middle class investors has grown phenomenally in last 4-5 years leading to huge imports of gold and resultant current account deficit.
With a view to provide a long term solution to this problem of gold imports, Government has announced in Budget 2013, launching of investment schemes returns on which will be scaled up with inflation and which therefore will provide protection from shocks due to inflation and will be good partial alternative to investment in gold.
First such scheme opened in June 13 was based on returns linked to Wholesale Price index and was targeted mainly for institutional investors. Since this scheme was based on wholesale price index, it did not enthuse much response from retail investors.
To address investment needs of retail investors RBI has launched another such scheme called as Inflation Indexed National Savings Securities-Cumulative (IINSS-C) in the second half of December 2013, subscription closing for which is now extended till March 14.
New scheme has been an improvement over similar Bonds issued in June 2013, interest rate for which was based on WPI (Wholesale Price Index) than on CPI (Consumer Price Index). For those who are not very much acquainted with these indices, it would be sufficient to know that DA to government employees is based on CPI and increases in CPI are generally higher than same in WPI because retail prices generally rise faster than Wholesale prices. For retail investors therefore better hedge against inflation is available in the new scheme since new Bonds are based on CPI. As per the latest October numbers, inflation based on WPI for October was 7 per cent while the CPI inflation figure was 10.09 per cent. Currently, the gap between the WPI and CPI indices is 3.09 per cent. With such difference between CPI and WPI, retail investors weren't gaining much in earlier bonds. Recognizing that there was not much scope for retail investors in the IIBs, the RBI has issued the Inflation Indexed National Saving Securities-Cumulative (IINSS-C).
These Bonds will be linked to Consumer Price Inflation Index (CPI)-based inflation, which is also a basis for DA being paid to Government employees. Like salaries, interest income can also become inflation free if these bonds address all related requirements of retail investors looking for real return on their hard earned savings.
Interest rate offered on these Bonds thus has two components. One is the fixed component of 1.5% p.a. which gives sort of additional interest over normal CPI based rate which will be a floating component. At today’s levels CPI on 2010 base is 10.09 so that at current position of these Bonds will give 11.6% returns (10.09% + 1.50%) linked to CPI. If at the end of next year due to inflation, CPI rises to say 12, yield on these bonds will be 13.5%.
If one compares this return to that of bank fixed deposits, the popular fixed income investment among retail investors, there's a clear additional return 3-4%, because on an average bank fixed deposits offer an interest rate of 9-9.5 per cent.
Since interest on these bonds will be at floating rate, investors who are used to fixed interest rate given on FDs could find it difficult to understand the concept of two interest rates - one that is fixed and one that is a floating interest rate linked to CPI. There is general awareness about floating interest to be paid on Housing and Car Loans taken by middle class customers from banks, but same concept normally does not operate when same class of customers give loans to Banks in the form of FDs.
Given the social security aspect of this new instrument and also given the fact that bond issue is still open for investment, this Article discusses whether and to what extent these Bonds in their present form are likely to achieve their slated objective of providing inflation free return on investment to small investors.
Main Features of the Bonds
Name of the Bonds –
Inflation Indexed National Saving Securities- Cumulative (IINSS-C)
Face value of one security –
Rs. 5,000 (Rupee five thousand) and minimum investment - `5,000 (Rupee five thousand). Maximum investment - `500,000 (Rupee five Lakh) per applicant per annum.
Rate of interest (per annum) –
Fixed interest rate (fixed rate of 1.5%) + inflation rate (Based on CPI with 2010 = 100 as its base). Final combined CPI will be used as reference CPI with a lag of three months (i.e. final combined CPI for September 2013 would be reference CPI for all days of December 2013).
Interest on these securities will be accumulated half-yearly, but will be paid only on maturity, or after redemption, whichever is earlier. Unlike FDs therefore these bonds in their present form do not provide any regular income to investors and will thus be a dampener for retired people.
Besides when inflation falls, the interest rate on this product too will fall and investors who may get used to increasing rates of interest may find it difficult to accept the lower rates.
Early Redemption –
After one year from date of issue for senior citizens above 65 years of age and 3 years for all others. The penalty charges at the rate of 50% of the last coupon payable for early redemption. Early redemptions to be allowed only on coupon dates.
One can't redeem these bonds until three years of date of issuance. After three years, this product will be redeemed only during coupon days, that is, whenever the interest is due to be paid on these securities.
A sole holder or a sole surviving holder of these bonds, being an individual, may nominate one or more persons who shall be entitled to the bonds and the payment thereon in the event of his death. The Non-Resident Indians (NRIs) can also be nominee of these bonds.
Form of Securities:
These securities will be issued in the form of Bond to be held in the Bond Ledger Account (BLA) and all the provisions of Government Securities Act, 2006 shall be applicable.
Limited to nominee(s) on death of holder [only individuals]. IINSS-C bonds won’t be tradable
Eligible as collateral for loans from banks, financial Institutions and Non Banking Financial Companies, (NBFC).
The eligible investors for these bonds would include individuals, Hindu Undivided Family (HUF), charitable institutions registered under section 25 of the Indian Companies Act and Universities incorporated by Central, State or Provincial Act or declared to be a university under section 3 of the University Grants Commission Act, 1956 (3 of 1956). The above proposed eligible investors in these bonds are the same as in the Relief/Savings Bonds.
These bonds would be sold/ distributed through all agency banks, including Stock Holding Corporation of India Ltd (SHCIL) in the form of Bond Ledger Account (BLA). The BLA for each applicant will be maintained in the centralised depository on the RBI’s portal (E-Kuber). The banks, including SHCIL, would act as interface for all customer services related to these bonds (such as receipts, repayments, recording change of address, nomination, transfer, early redemption, lien marking, etc.).
Income tax is likely to be a big factor which will pull down success of new bonds.
Tax treatment on interest and principal repayment would be as per the extant taxation provisions. Interest on the Bonds will be taxable under the Income-Tax Act, 1961 as applicable according to the relevant tax status of the bonds holder.
Entire interest on these bonds i.e. the inflation part and the 1.5% fixed part will be given as interest in IINSS-C, and will be taxable at marginal rates, under the head "Income from other sources", and not as capital gains even though the entire amount is received on maturity.
Like Cumulative National Savings Certificates, one must declare the interest every year as income and pay tax on it even though the money is not actually received in that year. These bonds do not fall within the list of deductions under Sec 80C. The interest thus would be subject to the income tax slab rate applicable to investor. If the inflation-compensating part had been capital gains, it could have benefited from indexation.
It is here that new bonds appear to be tax-inefficient compared to the earlier IIBs (based on WPI). In case of earlier (WPI based) bonds indexing of the principal is made every year according to the inflation rate for that year which provide two benefits. One, it protects the principal from inflation and one gets the real value of investment at the time of redemption.
Secondly, it results in an increase in cash inflow every year even when the fixed part at percentage level remains constant. For instance, if you one has invested Rs 1 Lakh in earlier IIBs, at fixed interest rate of 1.5%, actual amount of interest received in second year will be Rs. 1650 and not Rs. 1500 if WPI inflation rate is 10%. In this case, the fixed interest for the first year will be Rs 1,500 (1.5% of Rs 1 Lakh), and that for the second year will be Rs 1,650 (1.5% of Rs 1.10 Lakh). Principal at the beginning of second year will be increased to Rs. 1.10 Lakhs for calculation of fixed interest part.
From taxation point of view it is only the fixed part of interest that will become income of the year during the holding period whereas indexed principal at redemption date will be a capital receipt subject to taxation under long term capital gains. Difference between Indexed Principal repaid and Original Principal invested will be taxed as Long term Capital Gain and again with indexation benefits for calculation of capital gain.
While the IIBs are listed in the wholesale debt market and on stock exchanges, the IINSS-C will not be listed. Under Section 112 of the Income Tax Act, capital gains on the transfer of long-term capital assets (listed securities) are subject to tax. This is calculated at the rate of 20% of capital gains after reducing the indexed cost of acquisition, or 10% of capital.. gains without indexation. The capital gains will be computed by deducting the expenditure incurred in the transfer and cost of acquisition/ (indexed).
Though bonds do not get indexation benefits as per the third proviso of Section 48 of the IT Act since they get interest in the middle, the capital indexed bonds are an exception.
If one assumes that the inflation used by the RBI for capital indexing, and the cost inflation index set out by the Income Tax Department every year are close to each other, the entire inflation indexed part will be tax free for IIB holders.
Compared to WPI based bonds, investors in IINSS-C don't get benefit of splitting up of interest into two parts of interest income and capital gain for income tax purposes and their entire interest (Fixed part plus Inflation part) is taxed every year though all that interest gets paid only upon maturity or redemption. Interest is accrued and compounded every six months. Hence, retail investors have to pay tax on it in that financial year despite not getting any interest. This is because the tax on interest is supposed to be computed on an accrual basis. After adjusting for inflation and tax, investors in the higher tax bracket may get negative returns
This anomaly in tax treatment of two types Inflation bonds must be set right by RBI before it can hope big support of retail investors to new bonds.
For being successful therefore, new bonds should offer a choice to investors for either getting entire interest in cash every year which will also be taxed in those years as interest or getting only fixed part in cash every year and to receive inflation part as compounded principal at redemption. With such a choice after tax income on these bonds can be optimized by investors considering their respective tax slabs.
If factors of penalty on early redemption and inefficient tax structure are removed from the new bonds, it appears that with these revisions bonds will be very popular among middle class investor as really good partial alternative to gold and RBI can hope to collect good amount of savings through these bonds on perpetual basis apart from providing good social security to middle class population who has been so far neglected by all governments since independence.
Middle class investors should look for such improvements and invest when these actually happen.