Question map
With reference to the Indian economy, what are the advantages of "Inflation-Indexed Bonds (IIBs)" ? 1. Government can reduce the coupon rates on its borrowing by way of IIBs. 2. IIBs provide protection to the investors from uncertainty regarding inflation. 3. The interest received as well as capital gains on IIBs are not taxable. Which of the statements given above are correct ?
Explanation
The correct answer is Option 1 (1 and 2 only). The explanation for the statements is as follows:
- Statement 1 is correct: IIBs help the government reduce borrowing costs. Since these bonds provide a hedge against inflation, investors demand a lower "real" coupon rate compared to nominal bonds, which carry an integrated inflation risk premium.
- Statement 2 is correct: The primary objective of IIBs is to protect both the principal and the interest payments from inflation. By adjusting the face value based on inflation indices (like CPI or WPI), the purchasing power of the investor’s capital remains intact.
- Statement 3 is incorrect: There is no general tax exemption on IIBs. Interest income is subject to income tax, and capital gains are taxed as per the applicable norms. While the government may provide specific tax sops for certain retail schemes, IIBs as a category are not tax-free.
Since statements 1 and 2 are valid advantages and statement 3 is factually incorrect, Option 1 is the right choice.
PROVENANCE & STUDY PATTERN
Full viewThis is a classic 'Feature-Benefit-Trap' question. Statement 2 is a textbook definition found in standard sources (Vivek Singh/Singhania), but Statement 1 requires economic logic (Real vs Nominal rates), and Statement 3 is an 'Administrative Trap'. If you didn't know the specific tax rule, you had to rely on general Indian tax principles to eliminate.
This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.
- Statement 1: In the Indian economy, can the government reduce the coupon rates on its borrowings by issuing Inflation-Indexed Bonds (IIBs)?
- Statement 2: In the Indian economy, do Inflation-Indexed Bonds (IIBs) provide investors protection against uncertainty regarding inflation?
- Statement 3: In the Indian economy, are interest payments and capital gains on Inflation-Indexed Bonds (IIBs) exempt from taxation?
- Directly compares the coupon on a conventional (nominal) bond to the internal rate of return of an inflation-linked bond (ILB), showing the conventional coupon must include inflation.
- Implies ILBs separate inflation compensation from the fixed (real) coupon, so the fixed coupon on an ILB can be lower than the nominal coupon on a conventional bond that delivers the same IRR.
- Defines IIBs as securities that link returns to inflation to protect investors' purchasing power.
- Shows that inflation compensation is provided via indexation of returns rather than a higher fixed nominal coupon, supporting the idea that the fixed coupon component can be lower.
- Notes that ILBs are sometimes promoted as an alternative instrument, indicating they are considered a policy option.
- Warns that introducing ILBs requires demand (e.g., from institutional investors), implying practical constraints on whether issuing ILBs will succeed in lowering government borrowing costs.
States that IIBs are government securities issued as part of the market borrowing programme and that they protect both principal and interest against inflation.
A student could use this to reason that making IIBs part of normal borrowing gives the government an alternative instrument whose pricing (coupon) could differ from nominal G‑Sec coupons.
Defines inflation‑indexed bonds as securities where interest and principal are protected and linked to an inflation index.
Use the definition to compare how indexing changes the cash‑flow profile (real vs nominal) and thus how required nominal coupons might be set lower if investors accept inflation protection separately.
Explains that greater demand (e.g., foreign investment) for government bonds lowers yields and interest costs.
A student can extend this pattern to consider whether issuing IIBs might attract additional investors (or different investor types), increasing demand and pushing down overall coupon rates.
Lists as a proposition that 'Government can reduce the coupon rates on its borrowing by way of IIBs' alongside other features like investor protection and tax treatment.
Treat this as an example of a stated claim to be tested: compare the claim with market practice and tax/eligibility features to evaluate plausibility.
Notes that fiscal deficits increase government borrowings and that interest payments constitute a significant budgetary cost.
Use this fiscal pressure context to judge why the government might seek lower‑coupon instruments (like IIBs) and weigh trade‑offs between nominal coupon reduction and inflation‑linked payouts.
- Explicitly asserts IIBs provide a constant return irrespective of inflation.
- Directly states IIBs protect the investor against macroeconomic risks (including inflation).
- Defines inflation-indexed bonds as protecting both interest and principal against inflation.
- Notes linkage to an inflation index (CPI or WPI) and annual principal adjustment, which underpins protection.
- Contrasts earlier Capital Indexed Bonds (principal-only protection) with IIBs that protect both principal and interest.
- States IIBs are government securities issued under the government borrowing programme, implying sovereign backing and structured design for inflation protection.
Contains an explicit multiple‑choice exam item that lists as a proposition: 'The interest received as well as capital gains on IIBs are not taxable.'
A student could treat this as a reported claim from study material and then check the Income Tax Act or official notifications to verify whether that tax exemption exists.
Explains that IIBs protect both principal and interest and are government securities (G‑Secs) issued under market borrowing.
Knowing these are sovereign G‑Secs, a student could look up standard tax treatment of government securities vs. special exemptions to judge plausibility of tax‑exempt interest/capital gains.
Defines inflation‑indexed bonds as securities where interest and principal are adjusted by an inflation index (CPI/WPI).
A student could reason that if inflation adjustments are treated as part of coupon/principal, tax rules may separately treat inflation component and real return — prompting a check of whether tax law exempts either component.
Notes interest is offered on the increased principal after indexation, highlighting that payouts include inflation‑adjusted amounts.
A student could infer tax complexity (distinguishing nominal vs. inflation components) and thus search for tax provisions/notifications clarifying treatment of interest and indexed capital gains.
Summarises that capital gains tax exists under Indian direct tax law and that various incomes including interest and capital gains are covered by the Income Tax Act.
A student could use this general rule to judge that any exemption for IIB interest or capital gains would be an exception to standard tax treatment and therefore likely to appear explicitly in tax law or notifications.
- [THE VERDICT]: Conceptual Trap + Standard Books. Statement 2 is direct; Statement 1 is derived logic; Statement 3 is the eliminator.
- [THE CONCEPTUAL TRIGGER]: Financial Market Instruments (G-Secs) & Public Debt Management.
- [THE HORIZONTAL EXPANSION]: Compare IIBs with Sovereign Gold Bonds (SGBs) -> SGB interest is taxable, but capital gains on redemption are tax-exempt. Compare with 'Tax-Free Bonds' (issued by PSUs like NHAI/REC). Distinguish 'Capital Indexed Bonds' (only principal hedged) vs 'Inflation Indexed Bonds' (both principal & interest hedged).
- [THE STRATEGIC METACOGNITION]: When studying any financial instrument, fill a 4-column grid: 1. Issuer (Govt/Corp), 2. Objective (Why issue?), 3. Incentive (Why buy?), 4. Friction (Taxation/Liquidity). UPSC targets column 4 (Taxation) to eliminate candidates.
Inflation-indexed bonds adjust both principal and interest payments to inflation, ensuring returns keep pace with price level changes.
High-yield for fiscal and monetary topics: explains how real returns to investors are preserved and why nominal coupon design matters. Connects to government debt instruments, investor protection, and inflation risk management. Useful for MCQs on bond types and short-answer/essay questions on debt instruments.
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.5 Government Securities > p. 46
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > Inflation Indexed Bond > p. 265
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > Inflation Indexed Bond > p. 264
IIBs are issued as G‑Secs under the government's market borrowing programme and can be held for SLR purposes by banks.
Important for public finance and banking syllabus: links government borrowing composition to banking regulation (SLR) and demand for government papers. Helps answer questions on debt management, central bank liquidity, and banks' investment behaviour.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > Inflation Indexed Bond > p. 265
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.5 Government Securities > p. 47
Greater foreign investment in government bonds can lower domestic government bond interest rates and yields, easing borrowing costs.
Crucial for questions on interest-rate determination and external influences on domestic borrowing costs. Connects capital flows, bond market liquidity, yields, and government financing strategies—useful in both modern history/economic reforms and current affairs contexts.
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Indian Govt. securities will very soon join Global Bond Index > p. 48
IIBs adjust both principal and coupon payments to an inflation index, directly preserving real returns.
High-yield for monetary/financial polity questions: explains how real returns are maintained and distinguishes IIBs from nominal bonds. Links to topics on CPI/WPI, real vs nominal interest rates, and bond valuation under inflation.
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.5 Government Securities > p. 46
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > Inflation Indexed Bond > p. 265
IIBs are issued as government securities and form part of government market borrowings, providing sovereign backing and institutional eligibility (e.g., SLR).
Important for questions on public debt management and investor safety: explains demand, liquidity and regulatory roles of IIBs and connects to fiscal policy and banking regulations.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > Inflation Indexed Bond > p. 265
Nominal bonds lose value to unexpected inflation, whereas IIBs are designed to mitigate that erosion by indexing returns.
Core for macro/finance answers: helps analyze winners and losers from inflation, the rationale for inflation-indexed instruments, and policy choices like inflation targeting and real interest rates.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 4: Inflation > EFFECTS/IMPACT OF INFLATION > p. 70
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > Inflation Indexed Bond > p. 264
IIBs adjust principal and interest by an inflation index so investors receive inflation-protected returns.
Understanding how inflation-indexing alters nominal vs real returns is high-yield for questions on government securities, investor protection, and the impact of inflation on debt instruments. It links to topics on inflation measurement, real interest rates, and household/investor welfare.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > Inflation Indexed Bond > p. 265
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.5 Government Securities > p. 46
Sovereign Gold Bonds (SGBs) are the 'Logical Sibling'. Unlike IIBs, SGBs offer a specific tax exemption on capital gains arising on redemption to an individual. The examiner likely set the IIB trap in Statement 3 by borrowing this specific feature from SGBs.
The 'Double Benefit' Heuristic. Statement 3 claims BOTH interest and capital gains are tax-free. In the Indian tax regime, such 'double dip' exemptions are extremely rare (mostly restricted to PPF/EPF). For market-tradable bonds, usually at least one component is taxable. If a statement promises total tax immunity on a bond, it is 90% likely false.
Mains GS-3 (Fiscal Policy): Issuing IIBs aligns the Government's incentive with the Central Bank's. If inflation rises, the Govt's interest burden on IIBs explodes. Thus, IIBs act as a 'commitment device' for fiscal discipline, forcing the Govt to support Inflation Targeting.