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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.
- 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 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.
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