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Weekly Debt Update : Indian Bonds Entered the Big League By Pankaj Pathak, Quantum AMC
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Index Inclusion to drive Foreign Capital in Indian Bonds
Indian government bonds will be included in the JP Morgan GBI-EM Global indices with effect from June 2024. The inclusion would happen in a staggered manner with 1% of index weight addition every month, reaching the maximum weight of 10% in the index by Mar 2025.
The GBI-EM Index is widely followed with ~USD 236 billion of fixed income assets benchmarked to it. Thus, inclusion into this index would attract USD 25-40 billion of foreign portfolio flows into Indian government bonds over the next 12-18 months. Inclusion in the GBI-EM index also increases the chances of India’s inclusion in Bloomberg Global Aggregate Index which could attract another USD 10-20 bn of inflows.
Demand Supply Dynamic turned Favorable
Index Inclusion would completely change in the demand supply dynamics in the Indian bond market. Although ETF and Index related inflows will start from June 2024, active investors will likely front run the passive flows. FPI’s own less than 2% of total outstanding Indian bonds. This exposure could move higher to 3.5%-4% by the end of FY25.
The central government has front loaded the supply of G-sec in the first half of the year and the gross and net borrowing in the H2 FY24 will be Rs. 6.6 trillion and Rs. 3.8 trillion respectively in the H2 FY24. To recall, the net Gsec supply was Rs. 5.5 trillion in the H2FY23. The combined demand of Banks, insurance, pensions, provident funds and FPIs to be higher than total supply in the next six months. FPI demand will also be favorable for the bond demand supply balance in FY25.
Outlook
Despite the expected positive impact of the index inclusion, Indian bond yields have moved higher after the actual announcement. The negative impact was mainly coming from the elevated crude oil prices and rising US treasury yields. At the time of writing this report, the 10 year US treasury yield is holding around 4.5%.
Indian bonds will continue to take cues from US treasury yields. However, we expect the correlation between the two to remain low. In the current month, the 10 year UST has moved up almost 40 basis points, while the Indian 10 year bond yield has moved up only 3 basis points. Similarly over the last three months, the 10 year UST has risen by 68 basis points, while the 10 year Indian bond has moved up by only 9 basis points.
We maintain our constructive outlook on long duration bonds based on following: * The rate hiking cycle in India and most of the other major economies are now behind us. * Despite near term food price shock, the CPI inflation at broader level is showing softening inflation momentum. We expect the headline CPI inflation to decline sharply from current 6.8% reading to below 5% by Q1FY25. * The 10-year government bond is currently trading at over 65 basis points above the policy repo rate. Given the policy repo rate is near cycle peak, this spread looks significantly higher than its historical average during peak rate environment. * Demand Supply dynamic looks favorable supported by low net supply and expected increase in foreign demand. Portfolio positioning With the index inclusion news out, we increased the portfolio duration in the Quantum Dynamic Bond Fund portfolio by switching from 4-5 year bonds to 10-14 year maturity bonds. Currently, the bulk of the QDBF portfolio is positioned in the 5-10 years maturity government bonds. In the Quantum Dynamic Bond Fund we do not take any exposure in private sector companies and invest only in government securities, treasury bills and highest quality instruments issued by public sector undertakings (PSU) which are shortlisted under our proprietary credit research and review process. However the fund does take interest rate risk depending on our assessment of the market outlook. In the Quantum Liquid Fund we prefer the 3 month treasury bills and AAA PSUs over shorter maturity money market instruments. The money market is already pricing for the liquidity condition to tighten. Thus, we do not expect any material jump in short term rates in near term. In Quantum Liquid Fund we do not take any exposure in private sector companies and invest only in government securities, treasury bills and highest quality instruments issued by public sector undertakings (PSU) which are shortlisted under our proprietary credit research and review process. |
