Indian Bonds Going Global
Recently, there
have been increasing conversations about the potential inclusion of Indian government bonds into the global
bond indices. Indian bond market has defied the global trend of rising bond
yields over the last two months on an expectation that India will be included
in the JP Morgan GBI-EM Global Diversified Index and foreigners will
rush to buy Indian bonds.
India has one of the largest local currency government bond markets among emerging-market
economies with over Rs. 86 trillion (USD 1.2 trillion) of outstanding debt
stock. But long-held restrictions on foreign buying of its bonds have kept it
out of the top benchmarks used by global money managers.
In April 2020, the RBI removed all the foreign
investment caps for a list of government securities under the fully accessible
route (FAR). This opened up the possibility of India’s inclusion in the global
bond indices.
Currently, there are 22 bonds in the FAR list with
maturities ranging between 1 to 30 years. The total outstanding amount of FAR
bonds is Rs. 22.8 trillion (USD 287 billion).
Despite the removal of investment restrictions on Indian
debt, global investors held back India’s index inclusion citing problems with
capital controls, custody and settlement, taxations, and other operational
snags.
In October 2021, JP Morgan put India on the watchlist. It noted - “India (INR) government bonds are on track to be placed on Index Watch (observation period) for eligibility to the GBI-EM Global Diversified Index”. As per the agency “India is the largest ‘off-index’ market with the potential to reach a 10% allocation in the GBI-EM GD”.
The report also highlighted two key hurdles in the index inclusion –
(1)
ability to access the market through an international central security
depository (e.g. Euroclear)
(2) clarity on taxes.
There has been no progress on these two remaining issues
till now.
So, what changed?
JP Morgan removed Russian debt from all its bond indices
in March 2022 in response to Russia’s attack on Ukraine.
Russia had a
weight of about 8% in the JP Morgan GBI EM Index. Its removal led to an
excessive concentration among a few countries within the index. Now, 7
countries in the GBI-EM Index have the maximum allowed weight of 10%, while the
remaining 13 countries have a combined weight of only 30%.
This has fuelled an expectation that global investors
may overlook some of the remaining concerns and prefer to include India this
time.
India’s index inclusion would add diversification to
the index, enhance the yield and expand the market opportunities for global
debt investors. So, the benefits might outweigh the concerns.
What does it mean for India?
Unlike equities, Indian bond markets have failed to
attract any sizeable pool of foreign capital till now. Foreigners hold less
than 2% of Indian bonds; while the government is excessively relying on
commercial banks and the RBI to fund its large borrowing program.
Chart -I: Indian Bonds are
under-owned by foreigners
Source – www.asianbondsonline.adb.org, RBI, Quantum Research,
Data for India as of 16th Sep 2022, Korea as of Mar 31, 2022, China as of Sep 30, 2021, and all others are as of June 30, 2022
Index inclusion will
open up a source of durable demand for Indian bonds from investors who track
the index, particularly from the exchange-traded funds or ETFs. Even active
investors will be more comfortable investing in India when it becomes part of
the index.
Apart from the
direct impact of additional demand, there are other benefits as well.
§
The new demand source for government bonds might
also help in deepening the corporate bond market in India.
§
Potential foreign inflows into Indian debt will
expand the source of foreign capital which in turn will strengthen India’s
balance of payment situation and deepen the market for the Indian Rupee.
§
Foreign holding of bonds would enforce much
stricter discipline on the fiscal and monetary policy.
§ Increased
participation by foreign investors, would enhance the credibility of the Indian
bond market and will make it easier for the government and the corporate sector
to raise debt capital from global investors.
Clearly, India has a lot to gain from Index inclusion.
However, there are downsides as well. High foreign holding of debt might expose
Indian markets to external shocks. Large inflows-outflows linked to developments
in the global markets can have an outsized impact on the domestic bond and
currency markets.
Thus, additional safeguard measures will have to be
deployed to deal with any such external shocks.
What does the bond market expect?
As per estimates by some global investment banks,
India’s inclusion in the GBI-EM Index could attract around USD 25-40 billion
foreign inflows in the first year. Inclusion into Bloomberg’s Global Aggregate
Index could attract another USD 7-10 billion.
Currently, foreign investors holding Indian government
bonds are around USD 18 billion and corporate bonds are around USD 13.8
billion. A sharp jump in foreign demand will be a big boost for the Indian debt
market. It should drive bond yields lower and prices higher.
Chart – II: FPI has shied away from Indian Debt Since 201
Source – RBI, Quantum Research, Data up to June 2022
However, we expect it to be a story for the next year.
Even if JP Morgan announces India’s inclusion into its emerging market bond
index, it would take around 6-12 months for actual inclusion to start. The lead
time allows investors to set up accounts and make other operational
arrangements.
We expect actual inclusion to start sometime between
April – September 2023, assuming the announcement comes during this month or
the next. Based on the ongoing practise, the inclusion should happen with a starting
index weight of 1% which would go up to the final 10% weight in 10 months
period with a one percentage point increase in weight every month.
So, passive inflows should come during the second half
of 2023. There is a possibility that active global investors will load up the
Indian bonds before the actual inclusion. However, we do not expect any
significant inflows at this stage given the uncertainty over the future course
of monetary policy in the advanced economies.
Almost all the major central banks are hiking interest
rates and reducing liquidity to fight inflation. Bond yields across all the
major economies have been moving higher sharply. This might not be a conducive
environment for investors to take a tactical bet on an emerging market local
bond.
Thus, in the near term, the impact of index inclusion
would be purely sentimental. There is a possibility of a very short-term 10-20
basis points dip in bond yields following the index inclusion announcement. However,
we do not see a sustained fall in yields in the current year. We would prefer
to wait for the global central banks to slow down the pace of rate hikes before
taking any bet on India’s index inclusion.
Outlook
Indian bond yields have been
falling (bond prices rising) since mid-June 2022. The 10-year government bond
yield peaked at 7.6% in June 2022. It fell to 7.45% by June end, 7.32% by July
end, and 7.24% by August end and dipped to the lows of 7.07% during the second
week of September 2022. It gave up some of the gains over the last few days and
is currently trading around 7.24% as on September 20, 2022.
The decline in bond yields
started with a clamour of global growth slowdown and falling commodity prices. The
rally was extended on the expectation of index inclusion chatters.
The domestic monetary policy in India is near its fag
end. The market is already pricing for the Repo rate to peak around 6% by this year-end
and remain there for some time. However, the RBI might maintain its hawkish
tone beyond 2022 if the external monetary environment remains hostile.
We maintain our
view that the worst of the bond market sell-off is now behind us though there
we may not see a reversal happening anytime soon. Medium to long-term bond
yields should trade in a narrow range for the next 3-6 months.
Chart – III: Yield Spreads over Repo Rate are significantly above their long-term averages – pricing for potential rate hikes, demand-supply imbalance, and other uncertainties.
Source – Refinitiv,
Quantum Research; Data as of Aug 30, 2022
Past Performance may or may not sustain
We expect the 10-year
government bond yield to trade in a broader range of 7.1%-7.5%. The short end
of the curve will likely move higher with Overnight rates moving closer to 6%
by the year-end.
Considering the
duration-accrual balance, the 3-5 years segment remains the best play as core
portfolio allocation. The long end of the yield curve is vulnerable to an adverse
demand supply shock. However, any mispricing in this segment can be exploited
through tactical positioning from time to time.
Portfolio Positioning
In the Quantum Dynamic Bond Fund (QDBF), we have been avoiding long-term bonds for some time due to our cautious stance on the markets. The defensive positioning helped the portfolio ride through the market sell-off since the start of the year.
Given the bond yields are currently near the bottom of our expected yield range, we have turned defensive and created some cash-like positions in the portfolio to defend against any sudden jump in the market yields.
We would prefer to move into the 3-5 years maturity government bonds as a core portfolio allocation. We would also remain open and nimble to exploit any market mispricing by making a measured tactical allocation to any part of the bond yield curve as and when the opportunity arises.
We stand vigilant to react and change the portfolio positioning in case our view on the market changes.
What should Investors do?
The interest rate on short-term treasury bills has jumped about 190 basis points (1.9%) in the last 6 months. With more rate hikes coming, short-term treasury bill rates are expected to move higher. This suggests higher potential returns from investments in liquid and short-term money market funds going forward.
Chart – IV: Liquid Fund Yields Closely Tracks 2-3
Months Treasury Bill Rate
Source
– Refinitiv, Quantum Research; Data as of Aug 30, 2022
Past Performance may or may not sustain
Since the interest rate on bank saving accounts are not likely to increase quickly while the returns from the liquid fund are already seeing an increase, investing in liquid funds looks more attractive for your surplus funds.
Investors with a short-term investment horizon and with little desire to take risks should invest in liquid funds which own government securities and do not invest in private sector companies which carry lower liquidity and higher risk of capital loss in case of default.
Investors with more than 2-3 years holding period can consider dynamic bond funds which have the flexibility to change the portfolio positioning as per the evolving market conditions.
Medium to Long term interest rates in the bond markets are already at long-term averages as compared to fixed deposits which remain low. With higher accrual yield (interest income) and relatively lower price risk (compared to the last two years), dynamic bond funds are appropriately positioned to gain over the next 2-3 years.
Investors in dynamic bond funds or any other medium to long-term debt funds should be ready to tolerate some intermittent volatility associated with the movement in the market interest rates.
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article has been prepared on the basis of publicly available information,
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and reasonable as on date. Readers of this article should rely on
information/data arising out of their own investigations and advised to seek
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