Remedy for low deposit rate? The name's bond, inflation-indexed bond

The name is ‘bond’, inflation-indexed bond (IIBs) — that does not quite have the appeal of 007’s double-barrelled self-introduction, but IIBs are licensed to save, rather than to kill, and deserve the government’s serious attention in these uncertain times.

Where to put their hard-earned and fast-eroding savings is a question that stares most retirees starkly in the face. The old, reliable fixed deposit is no longer an attractive option. The post-tax return on a bank FD is likely to be below the rate of inflation and, further, banks are no longer the trustworthy institutions they used to be after nationalisation. Several have lost their financial solidity to swindlers who have, later, fled the country. Others have made unwise lending decisions and carry truckloads of bad loans on their books. And, now, the government has decided to privatise all state-owned banks save four.

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True, the RBI is unlikely to allow any bank to collapse and disappear and, then, there is deposit insurance, now up to ₹5 lakh in all accounts across banks (PAN- and Aadhaar-linked bank accounts prevent someone from claiming ₹5 lakh to be secured in each of several banks). Even if a bank is rescued, there could be periods when one’s money is locked up and there  is the risk that deposits above a threshold could be asked to be forgiven — that happened in Cyprus in 2012-13, when the Global Financial Crisis affected the divided island’s banks and big depositors saw parts of their savings being bailed in as equity to absorb the banks’ losses.

Indian laws do not permit this. But who knows when laws are changed, for the benefit of savers, of course, as the new farm laws are intended for the benefit of the farmers.

Are mutual funds a better option? Many savers thought so, until the IL&FS crisis showed that many mutual funds had lent money to shady promoters and to the holding companies of risky financial firms. Some of them then started investing in the stock market. Now that markets seem to have bid good-bye to the laws of gravity, it has been a breeze.

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But valuations on the stock market are clearly in bubble territory. Price-earning ratios of 30 and more are setting the market up for a fall, the only unknown factor being when. Of course, so long as US recovery remains tepid and the US Fed maintains its easy-money posture, markets could stay elevated. But these things will change. And except for the geniuses who have worked out how to time the market for entry and exit, for us ordinary mortals, deploying our savings in the stock market at its present crazy valuations is like sky-diving without a parachute: exhilarating all the way till that final, sickening thud.

What of small savings in the post office? These, on the plus side, do not run the risk of the deposit taker collapsing or being unable to honour its commitment to repay the principal and pay the interest. After all, the deposit taker is the government. But interest rates are low and the interest taxable, except in the case of schemes like the Public Provident Fund, or the Sukanya Samriddhi Yojana, where you can save a maximum of ₹1.5 lakh a year. As the government’s cost of borrowing from the market comes down, the interest rate on small savings will come down as well. Will the rate of return be larger than the rate of inflation? There is no guarantee.

This is where the inflation-indexed bond comes in. It could be fashioned after the American Treasury Inflation-Protected Security (TIPS) or the Canadian Real Return Bonds (RRBs). India’s own IIBs, discontinued in 2016, were modelled on TIPS, but less favourable to the saver in the frequency with which capital was revalued.

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In the TIPS scheme of things, the capital is protected against erosion by inflation. If you invest ₹1,000, when the bond is ready for redemption after, say, 10 years, the principal you get back is not just the ₹1,000 invested. It would be larger to the extent of cumulative inflation since the initial investment. The coupon is fixed, but the interest paid out varies, depending on how much the principal rises (or falls, in case of deflation). The bonds are tradable.

In the Canadian RRBs, the capital is protected against inflation, as with TIPS. In addition, the rate of interest is always kept above the rate at which the retail price index rises. In India’s case, the relevant price index would be the Consumer Price Index. Both the rate of interest and the par value of the bond will vary with the rate of inflation. RRBs are a better model for India. TIPS and RRBs offer capital protection: even in the case of deflation eroding the value of the principal below the initial investment value, that value is guaranteed to the investor.

Why should the government issue IIBs? If inflation is managed well, this could be a cheap source of borrowing, cheaper possibly than small savings. Since it is an asset class in itself, even when tradable like other government bonds, diversified investment portfolios would always have some room for IIBs. Or, if the government wants to restrict IIBs to senior citizens and offer a slightly fatter margin over the rate of inflation in the interest offered on IIBs, the new direct access the RBI plans for individuals to government bonds can be used to enable this.

For the investor, IIBs are a safe instrument in which to park a fair bit of savings, and get a return that is higher than the rate of inflation while protecting the principal from getting eroded by inflation. The remainder of savings can be invested in securities that offer higher rates of return but also carry higher risk. After all, diversification of the saving portfolio across the risk-reward spectrum is the way to get decent, predictable returns.