Inflation Index Funds

Inflation is definitely a cause of worry for every individual. If the purchasing power of money keeps getting reduced, then a person will not be able to sustain present living standard, unless his income is increasing proportionately.

Inflation is such a beast that it not only makes your present life difficult, but can ruin your savings/investments for the future. It is to be noted that before May 2005, SEBI prohibited any capital-protected products. But now SEBI, relaxed these rules, allowing issuers to offer funds that provide capital guarantee. Currently there are numerous fund houses marketing such capital guarantee funds, but inflation turns out to be a real beast.

It is no wonder that the “mehangai dayan” song is such a hit.

I am just waiting, when the government or financial institutions will start launching a inflation protection funds. Such inflation-indexed funds are not a novel idea and they definitely exists in other parts of the world. For e.g. Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation.

Reserve Bank of India published a paper on inflation-index funds [PDF] in December, indicating that these might become reality soon in India.

It is proposed that we may issue  IIBs wherein the principal is indexed and the coupon is calculated on the indexed principal, as set out in the discussion paper on Capital Indexed Bond issued by the Bank in 2005. 

In simple terms, here is how it works :

Assume the IIB are released with a 10-year bond with 2% interest to be paid semi-annually. It means every six months, interest at 2% will be calculated and paid to the investor. Assume you invested Rs 100 in January. So after six months, the interest needs to be paid. But before the interest is calculated, the principal is adjust to current inflation rate. In this case the principal (Rs 100) is first adjusted for inflation (assume 8%). So the inflation adjusted inflation will be Rs 108. The 2% interest will be calculated on this inflation adjusted  principal thus giving higher returns.

The key benefits of such a investment avenue is that it is risk-free way to beat inflation although the real returns are not very spectacular. It will be a great tool as a portfolio diversification method and specially useful for conservative investors or senior citizens.