If the 1990s was a seminal moment for Indian equities, it’s now the turn of India’s bond market to stake its claim in the limelight. Foreign ownership of Indian government bonds is less than 2% currently.
Any allocation to Indian bonds today is active and non-benchmarked, as domestic securities are not part of any global benchmark. From 28 June, though, Indian government securities will be included in the widely tracked JPMorgan GBI-Emerging Market bond index, with a 1% weight and an eventual 10% weight by next year.
Any manager who even passively tracks the JPMorgan emerging market bond index or uses it as a benchmark for their investments can no longer stay away from Indian government bonds. They will be forced to have an underweight, equal-weight or over-weight position in Indian government bonds. But they can no longer ignore and leave it at zero.
That is why the inclusion in the JPMorgan index is a seminal moment for India’s bond market.
Lessons from equities
Foreign Investors have invested a little more than $200 billion in Indian equity markets, which now have a market value of about $700 billion. Over time, foreign investment activity in the Indian equity markets has brought about depth, liquidity, reforms, regulatory changes, and some improvement in corporate governance and disclosures.
As foreign ownership in Indian securities increases, the domestic bond market may also see its depth and liquidity improve. More importantly, this will force the government and policymakers to ensure macro stability at all times. The government’s commitment to inflation targeting, real policy rates, and fiscal consolidation will need to be unwavering.
India’s fragile moment in 2013 due to a high current account deficit and currency depreciation was triggered by foreign bond investor outflows more than equity outflows. It is a lesson hopefully well-learnt.
In equities, until 2-3 years ago, foreign investors dictated the market price and valuation. That is now changing as local flows dominate market reaction.
Indian government bonds are almost entirely domestically owned. However, as foreign investing rises, their activity will start moving the markets at the margin. Especially so if the JPMorgan index inclusion is followed by India getting included in other larger emerging market or global bond indices, thus drawing in more foreign buying.
Short-term impact
Decisions on being overweight or underweight on Indian securities will depend on the usual factors such as bond valuation, expectations of yield movement, and currency trends. Active investors may want to be overweight on India.
The Reserve Bank of India is likely to cut rates shortly, which should lead to falling yields and an increase in bond prices. Also, the rupee has been kept relatively stable. This should make Indian bond returns in US dollar terms look attractive from a price and currency returns perspective.
Much of the potential index-related buying seems to have already been front-loaded by market participants and hence we are unlikely to see any major moves on the rebalancing day—28 June.
In the local bond market, purely as demand/supply, I do not see a major impact. I expect all foreign bond inflows to be sterlised by RBI, thus creating rupee liquidity. This would mean RBI may not conduct open-market operation purchases, which tends to be a demand source for bond markets. In fact, if we get large foreign flows, RBI may be a net seller of government bonds, as would public sector banks that hold excess government securities than required.
Long-term potential flows
Technically, given the current ownership rules on Fully Accessible Route (FAR) government securities, foreign investors can invest more than $450 billion in Indian government bonds. Cumulative investments till date is about $21 billion. So India has a long way to go.
India requires overseas investors to register as foreign portfolio investors to invest in the country. Indian government bonds are not euro-clearable. India has a 20% withholding tax on interest income. It also demands a tax certificate from a chartered accountant on every repatriation.
We are not making it easy for foreign investors.
Indian bonds have always had good carry (nominal yield/ interest rate). The challenge has been on currency-adjusted returns. Over the medium-term, one should expect 4-6% in US dollar terms from India government bonds (pre-tax).
However, I urge long-term investors to look at Indian bond returns over a 3-year rolling returns basis. That tends to be a full rate and currency cycle and captures a good sense of when to be overweight or underweight on India.
Global bond funds and hedge funds will be the dominant investor category. However, we will also see a decent share of long-term investors such as sovereign wealth funds, pension funds and insurance companies opening accounts and investing in Indian government bonds.
A global asset?
The demand for currency hedging, onshore and offshore, will increase as foreign investments rise. So there would be more depth and liquidity in those markets. The interest rate derivatives markets will also pick up, resulting in some more triangularity in the bond-currency-derivatives nexus.
Investors who do not wish to open FPI accounts in India but are desirous of India bond positions will seek out participatory notes and total return swaps in the global markets. This may increase volatility, and India will become more exposed to global factors. But in general, this is good for markets and market participants.
Of course, there is potential and there is reality. I called it a seminal moment, as the inclusion in the JPMorgan index indeed changes the way global investors will look at the Indian bond market. However, whether the Indian bond market becomes a global asset class over the next decade will depend on open and sound monetary policy, financial reforms, policy decisions, and an improvement in basic market design and structure.
The author is chief investment officer, Q India UK, an affiliate of Quantum Advisors India