The Budget has proposed introduction of bonds or National Savings Certificates whose

returns will be linked to inflation. In these instruments, the principal rises with inflation,
though it is still not clear whether these bonds will be linked to the consumer price
index (CPI) or the more closely-watched wholesale price index (WPI). The interest, called
coupon, is calculated on the adjusted (to inflation) principal. The coupon rate may or may
not rise with the price index.

For example, if the annual coupon is 8 per cent and the principal is Rs 100, the investor will
be paid Rs 8 a year. If the inflation index rises 10 per cent, the principal will become Rs 110.
The coupon will remain 8 per cent, resulting in an interest payment of Rs 110 x 8 per cent =
Rs 8.8.

Inflation-indexed bonds give returns that are more than the rate of inflation, ensuring that
price rise does not erode the value of investors' savings.

The exact structure of these instruments will be announced later.

Vivek Gupta, research head, CapitalVia Global Research, says, "This is encouraging for
investors as most of the times the returns which investment funds showcase are not
discounted for inflation. So, for a common man, it becomes difficult to know the real
returns."

WHY INVEST

These bonds can be used to diversify and stabilise the portfolio. This is because
their principal rises with inflation. But when inflation falls, the principal does not go below
the issue amount.

These bonds are redeemed at the inflation-adjusted principal or the amount for which they
were issued. "These bonds will give more choice to savers, particularly those who are risk-
averse and looking to get assured positive real returns. Like gold, these are a hedge against
inflation and store of value. Investors who desire predictable real cash flow can include
indexed bonds in their portfolio," says KP Jeewan, head, fixed income, Karvy Stock
Broking.

SPACE IN THE PORTFOLIO

How much a person should invest in these bonds depends upon his expectations about
inflation. "Ideally, the entire fixed income component of a risk-averse investor's portfolio can
be deployed in these bonds if they are offering an attractive yield over inflation," says
Jeewan.

Market experts say these bonds are ideal for all investors. They have been structured for all
individuals and institutions, as their basic purpose is to protect investors from inflation by
giving fixed and regular coupon payments.

While the main aim of the government is targeting people who invest in gold to hedge their
portfolios from inflation, it will be difficult for inflation-indexed bonds to completely replace
the demand for gold. This is because most investors accumulate gold for consumption. This
need cannot be substituted.

On the other hand, informed investors who use gold to hedge against inflation and are
buying gold exchange-traded funds or bars/coins can perhaps replace gold with these
bonds.