Let’s discuss the structure first. IIBs are issued at a face value of Rs 100 for tenure of 10 years at a coupon rate that is decided at the time of the auction, we take it as 5% for the sake of explaining here. In a regular bond, you would get Rs 5 each year as coupon and would get your Rs 100 back after 10 years. In inflation indexed bonds, on the contrary, the principal would get adjusted in tandem with the inflation and the number of times in a year that this adjustment would take place depends on the issuing authority- the Indian government, in our case. This means when inflation is 10%, the principal is increased by 10% and becomes 110. Now, the coupon of 5% is paid on this Rs 110 instead of Rs 100 and you get Rs 5.5 and not Rs 5, as the case would have been, had it been a regular bond and not an inflation indexed one. This Rs 110 will remain the principal amount till the time the next adjustment happens.
What will happen at maturity is more interesting. You will get back either the adjusted principal or the original principal, whichever is higher. If the adjusted principal reduces to Rs 95 due to deflation, you will still get back Rs 100, which is the original amount that you invested. And if the principal at the time of maturity is Rs 115, you will get Rs 115. This feature keeps your original investment secured and you do not have to worry about your principal withering away.
However, there are certain points of concern for you as well. Investment in IIB should be well thought about, before jumping on the bandwagon.
The measure of inflation is done through WPI, or Wholesale Price Index, which is the inflation that wholesalers face, while buying goods from producers. This inflation is much lesser than what we face each day, the CPI, or the Consumer Price Index. Thus, if you expect that your investment will hold a value at par with what market prices of goods and services that you spend money on, you will be disappointed. Another concern would be the lesser liquidity of bonds and corporate fixed income securities in India. The Indian bond market isn’t as well developed as in the other parts of the world. If you wish to buy them, you will have to go through huge paper work, open a CGSL account, specially meant for investment in securities issued by the government of India and then, get them transferred to your DEMAT account. On taxation front, the coupon you get would be taxable, which would reduce your in-hand returns further.
Overall, IIBs do not seem to be interesting enough to get an entry into your portfolio on priority, since there are enough other securities that would work much better.