The real value of money is based on the concept of time value of money, in that one hundred Rupees of present day is worth more than the hundred Rupees received at a future date. Here, real value of money means what one unit of money is capable of purchasing; in short, its purchasing power. For instance, if a person is able to get only 1 unit of a good with Rs.100 now as compared to 5 units of that good 10 years back. This happens because the price of the good has increased five times over 10 years due to inflation. Therefore, when you invest your money in bank deposits or in any other investments like bonds, debentures, equities, gold etc. the real return you get is the amount of nominal return you have received minus rate of inflation.
Real Return = Rate of Nominal Return – rate of Inflation
The inflation-linked bonds, or IIBs, are securities primarily issued by sovereign governments, designed to help protect investors from inflation. The investments in IIBs, the capital increases with the inflation, and actual interest is better than originally promised, unlike term deposits in banks, where a depositor receives a pre-defined static interest rate at the end of the tenure. However in case of deflation, interest payments decrease with the negative inflation but capital does not decline below the face value of bonds.
The following illustration helps you in understanding the concept of IIB.
A trench of inflation indexed bond is issued by the Government with a Promised rate of return: 2 percent
| End of the 1st year | End of the 2nd year |
| Principal : Rs.1000 | Principal : Rs.1040 |
| Inflation in the economy : 4 percent | Inflation in the economy : 5 percent |
| Inflation accrual : Rs.40 | Inflation accrual : Rs.52 |
| Principal at the end of the first year : Rs.1040 | Principal at the end of the 2nd year : Rs.1092 |
| Promised rate of return : 2 percent | Promised rate of return : 2 percent |
| Interest : 1040 x 2%= Rs.20.80 | Interest : 1052 x 2%= Rs.21.04 |
| Totalreturn:Rs.40(inflation)+Rs:20.80(interest)
= Rs.60.80 |
Totalreturn:Rs.52(inflation)+Rs:21.04(interest)
= Rs.73.04 |
In the event of adjusted principal goes below the face value due to deflation, capital will be protected and the face value of the bond would be paid at redemption along with promised coupon rate/interest rate on the principal adjusted against inflation.
The Reserve Bank of India auctioned its first tranche in 2013, linking to Wholesale Price Index (WPI) inflation, as WPI headline inflation was then used as the key measure of inflation. Since April 2014, RBI adopted consumer price index (CPI) as the key measure of inflation for its monetary policy stance.
Related article:
1. What are Bonds, coupons and yield to maturity?
2. What are convertible bonds, floating rate bonds and negative bonds?
3. What are foreign bonds, euro bonds and, global bonds?
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