Distribution holds the key to inflation bonds

The government and the RBI will reportedly make changes to the inflation-indexed bonds (IIBs) to make them more attractive to investors. Changing the product is not enough to ensure its success. Rather, the government should incentivise distribution. The problem with IIBs, much like the National Pension System that manages retirement savings, is marketing. Today, only banks and the Stockholding Corporation of India are authorised to market IIBs. Marketing is poor because there is hardly any incentive for distribution: banks are paid only a nominal handling charge on the subscriptions received by them. IIBs also compete with bank deposits. Given the limited pool of savings, banks will push savers to invest in long-term FDs, rather than IIBs.

So, it makes sense to enlarge the distribution channel. The government should allow brokers and agents selling financial products to market IIBs. Proper incentives and a wide distribution network will help the bonds take-off, in a big way. Retail price inflation is still high, and only IIBs offer a positive real rate of return — the nominal interest rate less the rate of inflation. On IIBs, the government will pay an interest of 1.5% every year, over and above the rate of inflation as measured by the consumer price index (CPI).

The larger point is that IIBsare meant to wean investors away from gold and, hence, should be marketed aggressively. Design flaws should be corrected. One change has already been made: the interest on IIBs is now linked to the CPI, instead of the wholesale price index. The interest on IIBs is taxable, unlike that on long-term infrastructure bonds. The posttax return is lower than inflation. Also, the penalty for early withdrawal is high: almost half of most of the interest payment. The government could address some of these issues.