A Seminal moment for India’s Bond Market.

Think about the mid 1990s,three decades ago. ?when Indian equities got included in the MSCI Emerging Markets Index. It was a ~7.5% weight; which now stands at ~16%. Foreign portfolio ownership (passive and active) of Indian stocks was zero in 1991; went above 20% and is now ~18% of total market cap.

?Think of this as that moment for the bond market. Foreign ownership of Indian government bonds is less than 2%. Any allocation to Indian bonds today is active and non-benchmarked, as India is not part of any benchmark. From 28th June 2024 though, India will be included in the JP Morgan GBI-EM bond index with a 1% weight and an eventual 10% weight by next year.

?Any manager who passively tracks that index (as an index fund / ETF) or uses this index as a benchmark for their investment, can no longer stay away from investing in Indian government bonds. They will be forced to have an under-weight, equal weight or over-weight position in Indian government bonds. But, they can no longer ignore and leave it at zero. That is why it is a seminal moment.

?Foreign Investors have invested just above USD 200 billion in Indian equity markets, which in market value now stands at ~USD 700 billion. Foreign investment activity in the Indian Equity markets over time, brought about depth, liquidity, market reforms, regulatory changes and some improvement in corporate governance, disclosures etc.

?As Foreign ownership in the government bond markets rise, bond markets will get a new buying source and the depth and liquidity of the markets may increase. More importantly, it will force the government and policy makers to ensure macro stability at all times as possible. The commitment to inflation targeting, real policy rates and fiscal consolidation needs to be unwavering.

?India’s fragile five moment in 2013 due to high current account deficit, with the eventual currency depreciation was triggered by foreign bond investor outflows more than equity outflows. It is a lesson hopefully well learnt.

?In equities, till about 2-3 years ago, it was true that the foreign investors dictated market price and valuation. That is changing now as local flows now dominate market reaction.

?Indian government bonds are almost entirely domestically owned. However, as foreign investing rise, their activity will start moving the markets at the margin. Especially so, if this index inclusion is followed by India getting included in other larger EM or global bond indices thus drawing in more foreign buying.

?Short-Term Impact

The decision to over or under weight will depend on usual factors like bond valuation, expectation of yield movement, currency trend. In the current times, we believe that active investors may look to over weight India. The RBI is likely to cut rates in the coming months which should lead bond yields to fall (bond prices will rise). Also, the currency has been kept relatively stable and is expected to remain so. This should mean Indian bond returns in USD 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 should not see any major moves on the rebalancing day i.e June 28, 2024.

?In the local bond markets, purely as demand/supply, I do not see a major impact. I expect all foreign bond inflows to be sterlised by the RBI thus creating INR liquidity. This would mean RBI may not conduct OMO purchases which tends to be a demand source for bond markets. In fact, if we get large foreign flows, the RBI may be a net seller of government bonds, along with PSU banks who hold excess government 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 USD 450 billion in Indian government bonds. Cumulative investments till date is ~USD 21 billion. So, India has a long way to go.

?India requires foreign investors to register as FPI to invest. Indian government bonds are not euro-clearable. India has a 20% withholding tax on interest income. India requires 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 a medium term, one should expect 4-6% in US dollar terms from India government bonds (pre -tax). However, I would 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 over/under weight India. (see chart above)

?Global bond funds/hedge funds will be the dominant investor category. However, we would also see a decent share of long term investors like SWFs, pensions, insurance companies ?opening accounts and investing in Indian government bonds.

?Other market impact:

The demand for currency hedging, onshore and offshore, will increase as foreign investments rise. So, one should see more depth and liquidity in those markets. The interest rate derivatives markets will also pick up ?and you will see some more triangularity in the bond-currency-derivatives nexus.

Investors, who do not wish to open FPI accounts in India, but remain desirous of India bond positions will seek out participatory notes, total return swaps in the global markets. All this may increase volatility and India will get more exposed to global factors, but in general this is good for markets and market participants.

?Ofcourse, there is potential and there is the reality. I called it a seminal moment, as it indeed changes the way global bond investors look at the India bond market. However, whether over the next decade, Indian bond market becomes a global asset class, depends on an open and sound monetary policy, financial reforms, policy decision and an improvement in basic market design and structure.

I commented on it to Menaka Doshi : https://www.bloomberg.com/news/newsletters/2024-06-27/what-india-s-inclusion-in-jpmorgan-bond-index-means-for-its-economy-markets?srnd=undefined

I wrote about this for Mint : https://www.livemint.com/opinion/online-views/seminal-moment-for-india-s-bond-market-indian-government-securities-included-in-jpmorgan-emerging-market-bond-index-11719489815993.html

I spoke to NDTV Profit : https://www.youtube.com/watch?v=xzEhdLtBkYs

Quantum Advisors India Pankaj Pathak' CFA