CAPITAL INDEXED BONDS :
Capital indexed bonds are inflation-protection securities. Such bonds, therefore, provide good hedge against
inflation risk. The benefits do extend beyond hedging. Capital index bonds can be used as a market indicator for
inflation expectation. This will help investors take a more intelligent decision on their current consumption.
Finally, the spot yield curve can be better constructed based on the real yields.
Inflation risk: A nominal bond is exposed to high inflation risk. This is the risk that inflation will increase, leading
to increase in interest rate. Essentially then, inflation risk is a sub-component of interest rate risk. A capital indexed bonds lowers the interest rate risk by neutralizing the inflation risk.
The effectiveness of the hedge will, however, depend on the appropriateness of the inflation index. The purpose
of issuing capital indexed bonds will not be fully served if the RBI were to use the Wholesale Price Index (WPI)
or the Retail Price Index (RPI) as the index for inflation. The reason is that these indices do not adequately
capture inflation as it affects the investors, especially the retail class. If banks are protected against inflation risk, they may, perhaps, pass on the benefits in the form of higher interest rate to the retail investors. That, in turn, provides retail investors a higher cushion against inflation risk. In such cases, more the inflation index is aligned to price levels affecting retail consumption, better the hedge.
Inflation expectation: Investors buy bonds by postponing their current consumption. There is, therefore, a tradeoff between investment and consumption. To make an intelligent decision between these two states of nature, investors need an indicator to measure inflation expectations. At present, due to lack of adequate measures, we assume that inflation expectation is the same as current inflation. If actual inflation were higher in the future, the investment decision may be unattractive. It is, therefore, important to proxy inflation expectation. A capital indexed bond helps in this regard.
If the RBI were to issue capital indexed bonds across the yield curve, we will have real yields for each maturitysector. We already have nominal yields as well for these sectors. The difference between the nominal and the real yields is a proxy for inflation expectation.