Detailed Explanation:

Answer: Option 1 — 1 and 2 only

Inflation-Indexed Bonds (IIBs) are government securities designed to protect investors from inflation by adjusting both principal and interest payments based on inflation indices. The government benefits from lower nominal coupon rates as the inflation adjustment is built into the bond structure, while investors gain protection against purchasing power erosion.

✅ Statement 1 – Correct: IIBs allow the government to offer lower coupon rates because the real return is guaranteed through inflation adjustment, reducing borrowing costs compared to conventional bonds with higher fixed rates.

✅ Statement 2 – Correct: IIBs provide complete protection to investors from inflation uncertainty as both the principal and interest payments are indexed to inflation (typically to WPI or CPI), preserving real purchasing power.

❌ Statement 3 – Incorrect: Both interest income and capital gains on IIBs are taxable in India as per the Income Tax Act; there is no special tax exemption for IIBs unlike some other specified securities.

📝 Short Notes: Inflation-Indexed Bonds (IIBs)

• Introduction: IIBs were first introduced in India in 1997 and reintroduced in 2013 by RBI to provide inflation protection to investors.
• Indexation: Both principal and interest (coupon) payments are adjusted based on inflation index (WPI or CPI-Combined).
• Real Return: Investors receive a fixed real rate of return plus inflation adjustment, ensuring purchasing power protection.
• Government Benefit: Lower nominal coupon rates reduce government's borrowing cost as inflation risk is transferred to the bond structure.
• Taxation: Interest income is taxable as per applicable income tax slabs; capital gains are taxable based on holding period (LTCG/STCG rules apply).
• Market Status: IIBs have had limited success in India due to complexity, taxation issues, and low investor awareness compared to other instruments.