Every time regulators or investors jawbone on this, the market reacts vehemently. Why is it a big deal for India to be added to global bond indices? What purpose do these indices serve? We answer these and other questions:
What is a global bond index?
The basic purpose of an index is to track the movement of a financial instrument on which it is based. Global bond indices help investors track the movement in bonds in multiple jurisdictions and aid in relative comparisons. Indices perform the important function of being a benchmark to investments by mutual funds, pension funds and other large investors that typically prefer to hold onto investments for longer periods. In other words, indices are guides to investments.
In the equity markets, there are sectoral indices, besides the main ones that track the most-traded stocks. In the bond market, there are indices that track high-yield risky bonds, emerging market bonds and government bonds.
Why is inclusion in global bond indices critical?
Global investors find it difficult and cumbersome to track bond markets in multiple countries. This is where bond indices come in handy. Investors track key indices globally to make investment decisions.
More importantly, global funds seek to either match or outperform the returns of indices. This serves as motivation to increase or cut investments in a particular bond market.
Inclusion in these indices makes such decision-making easier for investors. But above all that, index inclusion would mean a steady stream of dollar inflows from passively managed funds.
Global funds dedicated to investing in specific indices typically persist with their investments even during crisis times. Therefore, for an emerging market economy such as India that is starved for capital, index inclusion guarantees a certain amount of dollar inflows regularly.
What are the criteria for inclusion in bond indices?
Index holders or financial firms that manage bond indices have a series of criteria for countries wanting their bonds to be included in them. They must meet parameters on liquidity, safety, and returns.
The size of the market, sovereign rating, and ease of access are the main asks from index holders. The FTSE spells out a long list of conditions for inclusion in its emerging market bond index.
They include no capital controls, foreign exchange liquidity, robust hedging availability and fair tax policies. Yet another ask is settlement of investments in international clearing houses such as Euroclear. JP Morgan insists that trades be settled in Euroclear for inclusion in its emerging market bond indices.Does India meet the criteria for inclusion?
The Indian sovereign bond market ticks all the boxes in terms of liquidity, safety and even returns. However, the tax policy does not meet the criteria for settlement in Euroclear. This makes entry into bond indices that insist on Euroclear settlement difficult.
Even if settlement is allowed in domestic clearing houses, the process is cumbersome for foreign investors. This may put them off investments, according to bond market participants.Further, the government is not willing to exempt foreign investors from capital gains tax because it would be discriminatory for domestic investors.
While these issues persist, index holders could make an exception or offer to be lenient on a criterion if a country reflects strength on several other parameters. Strong investor interest could also sway opinion on inclusion, which seems to be the case for India.
What are the odds of India getting included in bond indices?
There are several issues that impede bond inclusion such as the capital gains tax policy. But global investors have pressed ahead, indicating an interest in India’s fixed income market.
The Reserve Bank of India’s move to allow foreign investors unbridled access to select bonds has also boosted sentiment. Some of these bonds will become eligible to be included in global indices next year.
Resolution is expected on some operational issues such as settlement of investment in global clearing houses. This would pave the way for Indian bonds to be included in JPM GBI-EM Global Diversified Index and the Bloomberg Global Aggregate Index. While the timeline for inclusion is unclear, some investors expect this to happen over the next 2-3 months.
How will India benefit from inclusion?
The benefits of inclusion in global bond indices are many. It makes investment decisions easy and that results in a steady stream of foreign inflows into domestic markets. Passive funds tend to allocate investments to a specific market based on indices and such funds are stable. Further, inclusion in global indices would strengthen a key investor base: foreign institutional investors. FIIs provide the much-needed liquidity and churn in the domestic bond market. The overall share of foreign investors is still low and the local bond market is dominated by domestic banks.
Greater participation would mean that bond yields could be kept in check and the RBI may not have to face the dilemma of stepping in as a buyer to reduce the government’s borrowing cost. A steady flow of dollars also keeps the exchange rate from depreciating too much.Global bond index inclusion is indeed a salivating prospect for India. But the key to cash in on investor optimism is to hasten the process of inclusion.