If oil prices remain high if the government increases minimum food support prices by a larger margin and if it increases the fiscal deficit, we could see even higher bond yields and possibly a weaker rupee on foreign investor outflows.
Foreigners have poured their faith into the Indian bond markets. Since the start of 2014 until November 2017, they have invested around Rs 3,00,000 crore (USD 46 billion) into the Indian bond market.
The investment is split almost equally between Sovereign Bonds and Corporate Bonds suggesting the diversity of flows and acceptance of Indian credit.
Against this, in 2013 outflows of Rs 67,000 crore were seen when foreign investors led by foreign banks dumped Indian bonds between May and September 2013 as the Indian rupee collapsed in the aftermath of the ‘Taper Tantrum’ and on worsening the domestic macro situation with high inflation and high fiscal deficit.
The UPA Government under then finance minister P. Chidambaram began cutting the fiscal deficit. The Reserve Bank of India, under the then new Governor Raghuram G Rajan, began with some institutional changes to increase credibility first by boosting the Forex Reserves (with the NRI FCNR (B) Deposits) and then by moving India to an flexible Inflation Targeting regime by targeting 4 percent Headline CPI target and 1-2 percent Real Rates
The RBI also encouraged more long-term flows into the Indian Bond Market from foreigners by creating a separate limit for Investors like Global Central Banks, Sovereign Wealth Funds, Pension Funds.
It also barred foreign investors from buying bonds of less than 3 years in maturity. This has also resulted in attracting ‘real money’ investors into the Indian bond market at the expense of the short term, speculative and volatile inflows from foreign banks ‘bond tourists’.
This is indeed a big positive which provides depth, stability and will further attract other long-term investors into the market.
Fiscal consolidation, Real Rate targeting, high FX Reserves and falling oil prices have been the bulwark of the India bond story since 2014 thus leading to significant relative outperformance both in INR terms for domestic investors as well as in USD Terms for the foreign investors.
India received a higher share of flows in its bond market than other EMs purely on the strength of its fundamentals and the institutional changes put in place.
But are we seeing the first signs of a shake-up?
Rising Oil prices have ensured that markets no longer expect rate cuts to come through. CPI inflation has risen from its lows and is now threatening to sustain well above the 4 percent headline CPI target set by the RBI.
Government’s dithering on its commitment to meeting the fiscal targets has added to the uncertainty. The worry is even more with the looming re-election of PM Modi in 2019 giving rise to speculations that the government may turn populist in the year ahead to garner votes from the marginalized farmer and backward community.
The Indian rupee, which remains a significant EM outperformer and has greatly aided in delivering high USD returns for investors could also be under pressure in 2018. We have seen historically that the Indian Rupee depreciates in the year prior to a General Election.
Concerned with the above developments, Indian bond yields have also reversed its trajectory and has increased quite a bit in the last 3 months.
The 10-year government bond now trades at 7.15 percent, it was 6.4 percent in August and almost the entire government bond curve is now above the 7 percent mark.
In our 2017 outlook, we had cautioned that ‘The best of the bond markets are behind us, Investors would do well to lower their return expectations from Indian bonds. Capital gains would no longer be the driver of bond returns’.
At that time in December 2016, the Repo rate was 6.25 percent, 10-year Indian government bond yield was at 6.3 percent and the entire bond curve was below 7 percent.
We are not that pessimistic about the bond market now given the current yield levels and valuations. But we remain cautious.
If oil prices remain high if the government increases minimum food support prices by a larger margin and if it increases the fiscal deficit, we could see even higher bond yields and possibly a weaker INR on foreign investor outflows.
But three things will continue to remain in favor of foreigners allocation to India bonds:1. The commitment by the RBI to maintain positive Real Rates will drive investments into India. Indian bonds also trade at higher nominal yields ~7 percent and higher spread to US treasuries.
2. Foreigners remain under-invested in the Indian bond market. Less than 5 percent of the Indian bond markets are owned by foreigners and many large foreign investors have never invested in the Indian bond market.
3. The recent upgrade by Moodys on India’s Ratings to one level above investment grade should allow many more funds to make allocations to Indian bonds.
It is thus important for the government and the RBI to retain and maintain the trust imposed by foreigners and domestic investors by continuing on the path of fiscal consolidation and to offer positive Real Rates at all times to bond investors.Disclaimer: The author is Head-Fixed Income & Alternatives, Quantum Advisors. The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.