ANALYSIS Disinflation may temper FPI flows into Indian bonds

Bonds

Inflows from foreign portfolio investors (FPIs) in the Indian bond market may remain volatile in the coming months on expectations of further easing in yields.

This is thanks to an easing in the rate of inflation, which typically has a direct effect on the bond market yield. Tempering levels of inflation improves the sentiments of bond traders and investors, and allows them to buy more bonds at the current price, to sell later at higher prices when yields start falling or stabilising at lower yields.

Bond yields and prices are inversely proportional. That is, when bond yields fall, prices rise, and vice versa.

“Debt flows may be tempered by falling rates (amid rising US yields) and we may have some positive bias emerging in equity flows. However, trends need a close watch, in our view,” said Kanika Pasricha, chief economic advisor at Union Bank of India.

A scenario of lower yields in the bond market coupled with further expectation of easing is perceived as a negative by foreign investors as it often narrows the difference between the yields of Indian and US bonds.

Usually, narrowing of spreads between India and US bond yields compels foreign investors to pull their funds from emerging economies and park the investments in their home countries, as a thinning differential could result in foreign investors earning lower returns, especially when adjusted for currency exchange rates.

India's retail inflation slowed to 3.16 percent in April from 3.34 percent in March. It is the lowest year-on-year inflation since July 2019, the government said in a statement.

Further, there is also an expectation of more rate cuts, of 50 basis points (bps), by the Reserve Bank of India in 2025-26. This will also have a downward pressure on the bond yield in India.

However, the easing compliance for FPI proposed by the Securities and Exchange Board of India and relaxation on investment limits in corporate bonds may help maintain foreign investors’ investment in Indian bonds in the long run.

Madhavankutty G, group chief economist at Canara Bank, said a 50 bps cut is priced in and if disinflation persists, another 25 bps rate cut cannot be ruled out.

However, he added that if we take disinflation to mean negative inflation, then the room to cut will be limited and we may have to think of rate hikes instead.