A bond that aids the investors to receive a constant return and is issued by the Sovereign are called Inflation-Indexed Bond (IIB). This return does not depend on the level of inflation in the economy. This bond is designed to protect the investors against what is called macroeconomic risk in an economy.
The effect of uncertainty of inflation is avoided over the life of the bond. This kind of bond helps in paying interest at fixed intervals and the principal amount is returned at the time of maturity.
Salient Features of Inflation-Indexed Bond (IIB)
- This bond can be traded in the secondary market.
- The investment limit is ten thousand to two crores.
- RBI can directly sell it through the auction method. This in turn is used by the government which means they are borrowing it.
- Protection is provided to both the principal amount and the coupon.
- Like any other fixed-income instrument works, this bond is also taxed.
Benefits of Inflation-Indexed Bond (IIB)
Benefits to Investors
Investors get a huge benefit when it comes to a long-term indexed Treasury bond. They will get a long-term asset with the help of a fixed real yield. Though in the past, it was assumed that one was subjected to high inflation risk.
Benefits received by Policymakers
Policymakers have the advantage of receiving information pertaining to real interest rates and inflation expectations in the market. One can get accurate information by using the liquid market for indexed treasury bonds.
Benefits met out to the U.S. Treasury
The US Treasury would be benefited from the savings present on what is called interest expense. Similar to how the investors are protected, the US Treasury would also benefit.
Limitations of Inflation-Indexed Bonds
Limitations because of Taxation
the advantages of indexed bonds are affected by taxation. There can be inflammation risks because of the taxation. The value of the indexed bonds falls because of taxation, causing a loss. but again when compared, the risk is lesser for indexed bonds than for nominal bonds. the tax rate causes the real yield to fall.
Effect of Market Liquidity
When considering indexed bonds for tax treatment, the liquidity of the market can be limited. It is seen that whatever the condition is the indexed bond market is less liquid than the nominal bond market. the Treasury has to pay a liquidity premium when there is much less liquid in the market for indexed Treasury bonds. Since things are uncertain, there Is always a possibility that investors have to change their holdings of security from time to time. another problem is that this adjustment is quite costly for illiquid assets as compared to a liquid asset. The issuer has to then pay and compensate the investors.
Limitations related to Indexing
When seen closely, if the inflation is single and immediately available, the lags are not too much and would not cause a heavy risk. But the lags can be a problem when the institutional arrangements are concerned. These arrangements are related to trading and settling bonds concerning coupon payment dates.
In the US financial markets, these inflation-indexed bonds are of great valuable innovation. This helps the investors, treasury and policymakers by providing useful benefits. The treasury interest expense is saved, investors and issuers of this bond are saved from the inflation risk. When combined with nominal bonds, it gives additional information on rates of interest and inflation expectations.
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