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5

Question 5

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?

AOptions

A
A) 1 and 2 only
B
B) 2 and 3 only
C
C) 1 and 3 only
D
D) 1, 2 and 3

BSolution

Let's analyze the statements regarding the advantages of "Inflation-Indexed Bonds (IIBs)":

1. Government can reduce the coupon rates on its borrowing by way of IIBs: IIBs offer investors protection against inflation, as their principal and/or interest payments are adjusted for inflation. Because investors are insulated from inflation risk, they are often willing to accept a lower real interest rate (or coupon rate) compared to conventional bonds, which do not offer such protection. This allows the government to potentially reduce its borrowing costs. This statement is correct.

2. IIBs provide protection to the investors from uncertainty regarding inflation: This is the primary advantage of IIBs. The principal value and/or interest payments of IIBs are indexed to a measure of inflation (e.g., CPI), ensuring that the real value of the investment is preserved, protecting investors from the erosive effects of unexpected inflation. This statement is correct.

3. The interest received as well as capital gains on IIBs are not taxable: In India, the interest received on IIBs is taxable as 'income from other sources,' and any capital gains arising from their sale are also subject to capital gains tax as per the applicable tax laws. They are not exempt from taxation. Therefore, statement 3 is incorrect.

Diagram for Q5

CStrategy

When studying financial instruments like bonds, understand their fundamental features, who issues them, what risks they mitigate or introduce, and their typical tax treatment. Distinguish between different types of bonds (e.g., conventional, inflation-indexed) and their unique benefits/drawbacks.

DSyllabus Analysis

This question is from the Indian Economy section, specifically pertaining to financial markets, government securities, and public finance.

EQuestion Analysis

Medium. Requires specific knowledge about Inflation-Indexed Bonds and their features.