Sherlock Holmes and the Great Indian Bond Inclusion

Chapter 1: Bond Inclusion Mystery

Sherlock Holmes sat in his armchair at 221B Baker Street, his violin resting on his lap. He was deep in thought, pondering the mystery of the bond market.

"Watson," he said, "I have been thinking about the inclusion of India in global bond indices, and its impact on Indian yields. It is a complex matter, with many moving parts. But I believe I have solved the mystery."

"Oh, indeed?" Watson asked. "And what is your solution?"

"The RBI will not be able to stop the bond rally," Holmes said. "The demand for Indian bonds will be too great."

"But the RBI will sell bonds to absorb liquidity that is infused after absorbing FX flows," Watson said.

"No doubt," Holmes said. "But Watson, you've overlooked the fact that the RBI does not hold any long-term bonds in its portfolio, and a significant portion of index purchases will be long-term bonds. After all, the index has a duration of more than seven years. So the RBI may sell shorter-tenor bonds, not longer-tenor bonds. Don't you see a mis-match?"

"But then will RBI not incease long term issuances to match this demand?" Watson asked.

"Most probably, yes. But the expected demand is so large", said Holmes.

"Why do you say that the demand is large." Watson asked.

"Watson, we are talking about tens billions of dollars of inflows. In past even a 7-8 billion dollar extra or lesser supply would make bonds react viciously", said Holmes.

"But this flow will come up to 2025 - its not coming today." Watson claimed.

"Yes, it will take time. But the active foreign investors and shadow index trackers will not wait so long. Look at what happened when China was included a few years back. We may not see a similar large rally in India, but we will see significant rally.", said Holmes.

"But Everyone knows the number. There are no surprises. Markets must have priced this already" Watson asked.

"Markets are quite inefficient to price demand/supply. It is usually when demand or supply hits that markets react. Look at how Friday auctions resets the yields so often. Look at how US yields reacted when supply hit incessantly, despite markets knowing of excess US borrowing.", said Holmes.

"But what about the global rise in yields?" Watson asked.

"That is irrelevant," Holmes said. "In the medium term, Macro-economics will get overshadowed by Micro-economics. Therefore, the price of Indian bonds will move in line with excess demand."

"But how long will the rally last?" Watson asked.

"That is difficult to say," Holmes said. "In the long run, the yields have to line with the underlying macro data. But that day is not today. Or in near future."

**** Chapter 2: Why bonds fell after the announcement

Holmes and Watson took a walk in the cold winter morning.

"But on Friday, after the announcement, bonds fell," Watson said. "Why is that?"

"That is the mystery that we must solve," Holmes replied. "There are a few possible explanations. One possibility is that some traders knew in advance that India would be included in the indices, and bought bonds before the announcement in order to profit from the subsequent fall in yields. Another possibility is that the market was simply overbought after the recent rally, and a correction was due."

"But what about the timing of the fall?" Watson asked. "It's strange that it happened on the day after the announcement."

"Yes, it is," Holmes agreed. "But it is also possible that the fall was caused by a combination of factors. For example, some traders may have sold bonds on Friday in anticipation of the RBI selling bonds in the near future."

"But the RBI hasn't announced any plans to sell bonds," Watson said.

"True," Holmes said. "But the market is always anticipating what the RBI will do. If traders believe that the RBI is likely to sell bonds in the near future, they may start selling bonds now in order to get ahead of the curve. After all the last weeks RBI data showed that RBI had sold bonds"

"So, what do you think we should do?" Watson asked.

"Don't worry. This will not lead to spike in yields. RBI will not sell anymore if yields rise. Thus there shoudl be a cap to the yields rise."

"But there must be instances when yields may rise" Watson asked.

"There always are Watson. One should not be blinded by their view not to see the underlying changes. If US yields continue gravitating higher it will put pressure on Indian yields. If govt uses this opportunity of lower yields to borrow more ahead of election, the new supply would lead to higher yields. If RBI decides to sell agressively it will be negative. If OIL and USD/INR keep rising they will be a concern.", replied Holmes.

"So, why aren't you worried?" Watson asked.

"Because there is no evidence that any of those things are occuring They are narratives. And narratives might move markets for a few days, but they don't make a trend."

***** Chapter 3: The final advice: Buy bonds. Add duration.

Holmes and Watson returned to 221B Baker Street.

"So, what is your advice to investors?" Watson asked.

"Buy bonds," Holmes said. "Add duration. Add long duration bonds."

"But what about the risk of rising yields?" Watson asked.

"That risk is outweighed by the potential for capital gains," Holmes said. "The demand for Indian bonds is already outstripping the supply. The term premium of 30-Year vs 10-Year and 5-Year is already at historic lows. It will likely compress further."

"And how long will the rally last?" Watson asked.

"That is difficult to say," Holmes said. "But I believe it will continue for some time. The RBI will eventually be able to catch up with the demand, but it will take time. The yields will ultimately align to macro data. In its own course."

"I see," Watson said. "Well, I shall take your advice and buy some bonds."

"Good," Holmes said. "Till the time you are aware of risk factors I spoke about, I believe it will be a wise investment. "