# Estimating the real yield for IIB at the auction on 4-June-2013

Inflation-indexed bonds in India – An investor’s perspective

A new 10-year inflation-indexed bond (IIB) will be launched on 4th June. 20% of this Rs. 1000 crore (US\$ 180mn) auction is reserved for retail investors, the rest institutional. In this note I discuss views to help arrive at the fair value of the real yield of this new bond. I estimate the economic value by assuming no arbitrage against a market traded nominal Government security of same maturity. The minimum yield I thus arrive at is 1.379% real yield with a 6% WPI inflation assumption. To this, market participants should add a premium for illiquidity and subtract inflation-risk premium. Overall, a real yield above 1% offers good value versus its nominal 10-year G-sec counterpart.

On 4th June 2013, the Reserve Bank of India will re-launch[1] inflation-indexed bonds, via auction, in the Indian market. This first issue after 1997 will be a 10-year bond (maturing in 2023) and will be indexed against the final wholesale price index (WPI) to provide inflation protection. The issuance size at the primary auction will be  Rs. 1,000 crore (US \$180 mn), 20% of which will be reserved for non-competitive bidders that include retail investors.

This asset being the first of its kind in India provides upfront guarantee on the real rate of return. Real return, as economists would note, is the total (nominal) return from an asset, adjusted for inflation. Mathematically, it reads:-

$(1 + Real) x (1 + Inflation) = (1 + Nominal)$

The stated objective for issuance of inflation-linked Government bonds in India is to provide an asset other than Gold for poor and middle classes to protect their savings from inflation. Diversion of funds away from Gold would reduce its import demand and potentially have a positive effect on the current account deficit. The success of this objective however remains to be seen and I will discuss it later on, on this website.

For appropriate price discovery and market development, the bond’s upcoming issuance through auction will include regular institutional investors such as banks, pension funds, insurance companies and Mutual funds who would competitively bid for 80% of the issuance size. A likely challenge for these participants would be how to price an asset that has not much precedence in India and no current outstanding real rate instrument to directly benchmark against. In this article, I share my views on this topic and try to suggest values for the variables that could go into pricing of this asset.

The real rate of return, as discussed earlier, is the key variable that bidders would arrive at through price discovery on the day of the auction. There are three components to which they need to assign values to arrive at the real yield : (1) economic estimate of real yield based on nominal government security yield and inflation expectations, (2) inflation risk premium and (3) illiquidity premium.

The economics based estimate of this instrument would be such that it provides returns equal to a conventional (nominal) Government security of same maturity, if held till maturity. The closest maturity bond that I can find on the current outstanding nominal G-Sec curve is 6.17% G.S. 12-June-2023[2] whose market-closing yield on 1 June 2013 is 7.26%, and is my starting point for valuing this new inflation-linked bond (IIB GS 5-June 2023)

Two variables are needed to determine the nominal cash flows of the inflation-linked bond (IIB). The real coupon of the bond (which at the time of issuance will also be the market yield of the bond) and an inflation projection until maturity of the bond. I make an assumption for the inflation projection and work out the real yield by using the following methodology on an excel spreadsheet:

1. Lay down the known cash flows of the nominal Government security (6.17% G.S. June-2023)
2. Create an inflation projection until March 2023. Statisticians would note that an inflation time-series could be broadly split into trend and seasonality components. For first iteration, I assume a trend rate of 4% WPI inflation. Since the IIB is a semi-annual bond, meaning it will have two cash flows during a year, it is important to work out the seasonal component of inflation to understand inter-month variability[3].
3. Using (2), work out the reference indices and index ratios relevant for the cash flow dates of the IIB (assuming a maturity of 5-June-2023 on both the nominal and inflation-linked bond)
4. Assume a real coupon ( r ) for the IIB and using (3) project the cash-flows of the IIB until maturity (5 June 2023)
5. Discount the cash-flows in (4) to present value using the NSE zero-coupon yield curve for the day of the valuation.
6. Using simulation (equivalent to the ‘goal seek’ function in excel) work out the real coupon ( r ) such that the sum of the discounted cash-flows in (5) match the current market value (based on dirty price) of the nominal Government security (from (1) ).
7. Repeat steps (2) through (6) by changing the assumption for trend rate of inflation.

I therefore arrive at real yield estimates for different assumptions of trend inflation as outlined in Table 1.

Table 1: Economic real yield estimates for different levels of assumed WPI inflation

 Assumed trend for WPI inflation rate Implied Real Yield 4.0% 3.2776% 4.5% 2.7983% 5.0% 2.3221% 5.5% 1.8490% 6.0% 1.3790% 6.50% 0.9119%

The future trend rate of inflation is of-course unknown. An investor makes an educated guess using both technical methods and through experience. There is always a subjective component. I look at the following:-

a)    Observe historical values for WPI inflation:

The yearly rate of WPI inflation is very volatile and it is therefore hard to estimate a long-term trend value by just observing year-on-year WPI inflation numbers.

Over a very long term (10-years) however, inflation tends to be reasonably stable. In the chart here (figure 2), I have plotted the history of annualised inflation observed over 10-years ending in the month mentioned on the x-axis. As can be seen, inflation has ranged between 5.59% and 6.48%.

b)     Estimate the real yields realised historically by assets available for investment in India and then by taking asset risks into account, work out what real yield should an IIB offer in comparison to other assets.

Table 2: Annualised real yields realized over last 10-years

 Over 10-years until May-2013 Over 10-years until May-2012 Over 10-years until May-2011 CRISIL 10-year Gilt Index -0.81 0.14 NSE Government Security Index (composite – total return) -1.57 -1.70 0.68 Nifty 12.21 9.83 11.35 Sensex 12.91 10.58 12.02 Gold (in INR) 11.28 12.36 11.65

-ve real rates

Table 2 shows that government security indices in India have yielded negative real rates over the last 10-years. Given the rampant inflation seen, this is not a surprise. Globally real rates have turned negative and visible through inflation-linked market yields in countries where the product is traded. It will not be a surprise if negative real rates are seen over the coming years in India too and from that perspective the upcoming auction could be interesting to invest in.

Taking analysis from (a) and (b), I would pick the row for 6% WPI inflation from table 1 and would demand a real yield of at least 1.379% to invest in this product.

Illiquidity premium and all that jazz…

To finally tailor this economic estimation of the real yield to market conditions, the following two premiums should be considered:-

a)     Inflation-risk premium (-):- International experience suggests that market participants attach a risk premium to account for the uncertainty of the expected rate of inflation. This premium acts in favour of the IIB and should therefore bring the real yield down marginally.

It is hard to estimate this number. If I look at the chart for WPI inflation in India, my sense is that it is high and volatile compared to inflation rates in some of the developed countries. Any estimate for the inflation risk premium in India should therefore be greater than the value for this premium these developed markets.

b)   Illiquidity premium (+):- Given that these are relatively new instruments and that there are relatively few entities that participate in an inflation-linked market, IIBs tend to trade illiquid compared to their equivalent nominal Government securities. It is because of this that market participants demand an extra yield for purchasing an inflation-linked bond. Again this premium is hard to determine objectively, but an estimate can be made by comparing the history of the spread between an illiquid nominal Government security and a benchmark on-the-run security.

It remains to be seen at what level the auction is subscribed. Since retail investors are part of the non-competitive segment of the auction, it is not for them to be concerned about placing a bid in the market. As discussed above, a real yield of above 1.379% would make sense.

Errata: This is a revised version of the analysis published on 1st June 2013.

[1] The first launch was in 1997 and was not very successful. The upcoming issue is a modified structure in line with the Canadian real rate bond model, being successfully traded in international markets.

[2] Note that there is an 8-day difference between the cash-flow dates of the two bonds, which I am ignoring in this analysis. In my calculations, I have assumed that both the bonds mature on 5th June 2023. Readers should be mindful of a marginal error because of this.

[3] For this analysis I have used the seasonal factors published in a ‘report of the Internal Technical Group on Seasonal Movements in Inflation’ by the RBI in 2008.