“It’s a matter of ‘when’ and not ‘if’ India will join the bond index,” insists Arihant Bardia, Founder and CIO, Valtrust Capital. Given the size of its government bond market, India may eventually achieve 10% in the index once inclusion is completed at the expense of some other emerging markets. Post inclusion, investments made based on the composition of the index are expected to bring in estimated inflows of $30-40 billion to India. Suyash Choudhary, Head – Fixed Income, IDFC AMC, says, “The expectation is that the while flows associated with actual index inclusion may take some time, and the weight assigned to Indian bonds in the index itself would only gradually go up, other ‘fast money’ flow may preempt this and start coming in.” A big influx would push government bond prices up and drive yields lower.
The bond market is already anticipating this move. The yield on 10-year government bonds softened to 7.15% as local investors took positions in longer duration bonds. But will this initial cheer set the stage for a longer rally for government bonds? Should investors use this opportunity to bet on long term gilts? “With the 10-year GSecs hovering around 7.3%, long duration gilt funds make a great investment choice,” Bardia says. However, be cautious. The government’s planned higher spending and the heavy borrowing it entails remains an overhang on bond prices. Larger supply of government bonds without matching incremental demand would exert downward pressure on bond prices.
Bond prices and yields move in opposite directions. According to Choudhary, the issue of duration absorption may still persist after the initial euphoria subsides. “Nothing changes our underlying view that if there’s one point of concern that bond markets ought to have over the medium term, it is the amount of duration supply. Absent offshore investors meant RBI stepped in to buy bonds as a means to expand its balance sheet. With index inclusion, offshore investors will buy bonds and RBI will get the dollars to expand balance sheet. Then RBI wouldn’t need to buy bonds. Either way, over the medium term, the eventual effect on bond yields may be similar.”
Beyond this, the external environment has turned more hostile for Indian bonds. The 10-year US treasury yield has moved up after the US Federal Reserve’s hawkish stance suggesting rate hikes will continue. Initial expectations of a tempering in the Fed’s stance in view of slowing economic growth were blown out of the water. Other major global central banks also appear intent on following through on aggressive rate hikes. Pankaj Pathak, Fund Manager – Fixed Income, Quantum MF, argues, “This is not a conducive environment for foreign investors to invest in emerging economies. Thus, we do not expect large inflows from foreign investors immediately even if India gets inducted into the global bond indices. However, it would be sentiment positive for domestic investors and might extend the bond rally for some more time.” Says Sandeep Bagla, CEO, Trsut MF, “Duration funds could gain immediately though the market has built in possibility of inclusion. However, eventually yields will depend on inflation trajectory.”
Given the hovering clouds, experts suggest avoiding incremental investments in long duration funds or bonds. Pathak contends, “Considering the duration-accrual balance, the 3-5 year segment remains the best play as core portfolio allocation. The long end of the yield curve is vulnerable to an adverse demand supply shock.” He expects the 10-year government bond yield to continue to trade in a broader range of 7.1%-7.5%. Choudhary concurs, “Given how unforgiving the global environment is, we don’t want to be too ‘tactical’ with our portfolio strategies by trying to chase the bull flattening (long-term rates decreasing quicker than short-term rates). We continue to find the most value in 4-5 year government bonds.”