For quite some time now the Finance Minister (FM) has been worried about the Indians' obsession for gold. In his opinion, the love for gold has led to an increase in imports of the yellow metal. This in turn has contributed towards the higher current account deficit that has plagued the country's finances. As a result he has decided to address one big reason as to why Indians prefer gold as an investment. And this reason is that it provides a hedge against inflation. To address this concern, the FM has introduced the inflation indexed bonds or IIBs. So will this induce investors to shift focus towards bonds instead of gold? We don't think so.
There are several reasons why we don't think this would succeed. The first is the structure of the bonds. The principal as well as the interest payments on the bonds would be indexed to inflation. Let us assume that the bond's principal value is Rs 100, it pays a coupon rate of 10% and the rate of inflation is 10%. The indexed values paid to the investor would be Rs 110 as principal and 11% as coupon rate. But the big problem in India is what the rate of inflation would be used for this? As per the guidelines, the bonds are linked to the WPI (wholesale price index). It is a known fact that the consumer inflation is much higher. Therefore the investor is not really protected against inflation if the IIB is linked to WPI.
In addition to this, the bond markets in India are still at a nascent stage. Though institutional investors do participate in the market, retail investors have pretty much stayed away. They need quite a bit of pushing to enter this space and this may prove to be an expensive deal for the dealers. Moreover due to the underdeveloped market condition, the liquidity in the markets is very low too. Something that makes it too risky for the retail investor.
On the other side is gold. It not only provides a hedge against inflation but also enjoys a safe haven status. In recent times, the prices of the yellow metal have corrected quite a bit. A large part of this correction is attributable to the sense that the global economy is on a recovery mode. Let us face it that the truth is far from this. Governments have applied a temporary balm through quantitative easing programs. But things are still not on the path of recovery. Emerging economies are slowing down. Developed economies are in recession. Sooner or later investors around the world will wake up and realize that the clouds of doom have not yet passed. During such times gold would be back in vogue.
In a nutshell, the FM wants investors to turn to IIBs. But these bonds are linked to WPI and not to the CPI which is inflation that bites into the investors' pockets. Therefore they offer very little by way of relief to the investors. Given this and the fact that gold has more long term benefits, investors are more likely to continue holding gold in the portfolios. It therefore pays to remain invested in the yellow metal through a reasonable allocation in your overall portfolio.
There are several reasons why we don't think this would succeed. The first is the structure of the bonds. The principal as well as the interest payments on the bonds would be indexed to inflation. Let us assume that the bond's principal value is Rs 100, it pays a coupon rate of 10% and the rate of inflation is 10%. The indexed values paid to the investor would be Rs 110 as principal and 11% as coupon rate. But the big problem in India is what the rate of inflation would be used for this? As per the guidelines, the bonds are linked to the WPI (wholesale price index). It is a known fact that the consumer inflation is much higher. Therefore the investor is not really protected against inflation if the IIB is linked to WPI.
In addition to this, the bond markets in India are still at a nascent stage. Though institutional investors do participate in the market, retail investors have pretty much stayed away. They need quite a bit of pushing to enter this space and this may prove to be an expensive deal for the dealers. Moreover due to the underdeveloped market condition, the liquidity in the markets is very low too. Something that makes it too risky for the retail investor.
On the other side is gold. It not only provides a hedge against inflation but also enjoys a safe haven status. In recent times, the prices of the yellow metal have corrected quite a bit. A large part of this correction is attributable to the sense that the global economy is on a recovery mode. Let us face it that the truth is far from this. Governments have applied a temporary balm through quantitative easing programs. But things are still not on the path of recovery. Emerging economies are slowing down. Developed economies are in recession. Sooner or later investors around the world will wake up and realize that the clouds of doom have not yet passed. During such times gold would be back in vogue.
In a nutshell, the FM wants investors to turn to IIBs. But these bonds are linked to WPI and not to the CPI which is inflation that bites into the investors' pockets. Therefore they offer very little by way of relief to the investors. Given this and the fact that gold has more long term benefits, investors are more likely to continue holding gold in the portfolios. It therefore pays to remain invested in the yellow metal through a reasonable allocation in your overall portfolio.
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