Change set
Pick exam & year, then Go.
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 investorâs 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
Guest previewThis 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.
Web source
Presence: 5/5
"For a conventional bond4 to provide the same internal rate of return (IRR) as the ILB described in table 3.1, its coupons must be close to the real interest rate plus inflation. In fact, because of the impact of inflation on the coupon payments, the nominal coupon should be 3 percent"
Why this source?
- 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.
Web source
Presence: 4/5
"Inflation Indexed Bonds or IIBs are a type of debt security designed to protect investors from inflation risk. The primary purpose of IIBs is to provide investors with a means to protect their investments from the eroding effects of inflation. By linking the returns to inflation rates, IIBs help ensure that the returns maintain their purchasing power over time."
Why this source?
- 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.
Web source
Presence: 3/5
"Inflation-indexed bonds have sometimes been promoted as an alternative instrument for economies with high inflation records, although this is not necessarily the best solution. Furthermore, it is not enough just to introduce this instrument, it is also necessary to develop the demand from institutional investors, in particular pension funds."
Why this source?
- 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.
- 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.
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > Inflation Indexed Bond > p. 265
Strength: 5/5
âInitially, IIBs were issued in the name of Capital Indexed Bonds (CIBs) during 1997. The CIBs provided inflation protection only to principal and not to interest payment. However, IIBs provide inflation protection to both principal and interest payments.
IIBs are G-Secs and are issued as part of the Government market borrowing programme. They are eligible for maintaining Statutory Liquidity Ratio (SLR) by banks.â
Why relevant
States that IIBs are government securities issued as part of the market borrowing programme and that they protect both principal and interest against inflation.
How to extend
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 GâSec coupons.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.5 Government Securities > p. 46
Strength: 4/5
âThey can be of different categories: ⢠Fixed rate bonds: Interest rate is fixed till maturity⢠Floating rate bonds: The interest/coupon rate is not fixed and can be linked to the yield of Treasury bills⢠Inflation indexed bonds: Interest and principal both are protected against inflation and can be linked with any inflation index like CPI or WPI. Every year principal isâ
Why relevant
Defines inflationâindexed bonds as securities where interest and principal are protected and linked to an inflation index.
How to extend
Use the definition to compare how indexing changes the cashâflow profile (real vs nominal) and thus how required nominal coupons might be set lower if investors accept inflation protection separately.
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
Strength: 4/5
âThis investment by foreigners will be treated as Govt. of India's external Debt.⢠More investment by foreigners in the Govt. of India bonds will lead to a lesser interest rate on Govt. bonds and hence lesser yield and this will also increase liquidity (more trade and easy conversion into cash) in Indian Govt. securities. This will also ease pressure on Govt. borrowing from the domestic market and hence domestic interest rate and yield will also come down.⢠Right now, when foreign investors (NRIs, FPIs) purchase corporate bonds or Govt. bonds in India then they require approval from SEBI. But if an investor wants to invest in Govt. securities through Global Bond Index, then this prior approval from SEBI needs to be removed.⢠Earlier there was a cap/ceiling as to how much non-residents (foreign) investors can invest in bonds in India.â
Why relevant
Explains that greater demand (e.g., foreign investment) for government bonds lowers yields and interest costs.
How to extend
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.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.31 Previous Years Questions > p. 123
Strength: 3/5
âGovernment 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? ⢠(a) 1 and 2 only: (c) 1 and 3 only; (b) 2 and 3 only: (d) 1, 2 and 3 ⢠51. Consider the following statements: [2022]⢠1. Tight monetary policy of US Federal Reserve could lead to capital flight.⢠2. Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs).⢠3.â
Why relevant
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.
How to extend
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.
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 5: Indian Tax Structure and Public Finance > IMPLICATIONS OF FISCAL DEFICIT > p. 111
Strength: 3/5
â⢠It implies greater borrowings by the Central Government. Borrowings from RBI raise the money supply in the economy, which results in rise in the general price level over a period of time. This leads to inflationary spiral.⢠Its affects GDP growth as a significant amount of budgeted revenue is spent on the payment of interest on borrowings by the Central Government, thus resulting in reduced investment.â
Why relevant
Notes that fiscal deficits increase government borrowings and that interest payments constitute a significant budgetary cost.
How to extend
Use this fiscal pressure context to judge why the government might seek lowerâcoupon instruments (like IIBs) and weigh tradeâoffs between nominal coupon reduction and inflationâlinked payouts.
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 GâSec coupons.
Defines inflationâindexed bonds as securities where interest and principal are protected and linked to an inflation index.
Use the definition to compare how indexing changes the cashâflow 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 lowerâcoupon instruments (like IIBs) and weigh tradeâoffs between nominal coupon reduction and inflationâlinked payouts.
This tab shows concrete study steps: what to underline in books, how to map current affairs, and how to prepare for similar questions.
Login with Google to unlock study guidance.
Discover the small, exam-centric ideas hidden in this question and where they appear in your books and notes.
Login with Google to unlock micro-concepts.
Access hidden traps, elimination shortcuts, and Mains connections that give you an edge on every question.
Login with Google to unlock The Vault.