A Long Awaited Inclusion: Bond Strategy Update

Enough has been written already on the much looked forward to announcement by JP Morgan that India will be included in its Emerging Market Global Index starting 28th June 2024. India’s weight in the index will rise to 10% by 31st March 2025. Additionally, India will also be included in other smaller indices run by JP Morgan (like the JADE Global Diversified index). All told, and accounting for active money flows that may want to position ahead of the actual index inclusion, market expects USD 25 – 30 billion of flows into the local bond market over this time frame. An additional consideration is whether other indices outside of JP Morgan may now be more favorably inclined to include India’s bonds. If this were to happen then the size of flow may potentially turn out to be even larger over the next year and a half.

The development is unequivocally positive even as the initial reaction of the bond market has been very muted. Market participants have been ignoring the recent rise in US yields as well as commodity prices, waiting to make money off the index inclusion news. In the event, the market didn’t prove to be as accommodating and the fall in bond yields post index announcement turned out to be very fleeting. Indeed, at the time of writing, yields are in the vicinity of where they used to be before the JP Morgan announcement: a classic case of ‘sell the news’, as it were. The actual index-related investment flows are still 3 quarters away, even as there may be some active money interest in the run up to that. Also, the global environment remains quite hawkish with developed market central banks firmly communicating higher for longer policy rates.

Nevertheless, there is reason to revisit portfolio strategies in light of this announcement, in our view. Unless the recent march up in US bond yields continues unmitigated, it is likely that Indian bond investors will look to ‘buy the dip’ in anticipation of the flows ahead. This is especially true since even as net government bond supply in the current quarter has been particularly high at approximately 41% of the full year’s net supply, it drops meaningfully to less than half this amount for the next 2 quarters. Furthermore, demand for duration has remained relatively robust thus far and it is unlikely that there is any significant steepening of the yield curve in the near future.

Another factor for consideration: the index flows when they come will translate into additional rupee liquidity as RBI buys the incoming dollars. This has led to speculation that RBI may do OMO bond sales to neutralize the excess liquidity. Hence, the argument goes, there may not be any additional demand for Indian government bonds as buying by foreign investors will get neutralized with selling by RBI. While this may happen to some extent, one must remember that India sees annual liquidity drainage of around INR 250,000 crores (equivalent of approximately USD 30 billion) on account of rise in currency in circulation. Thus it is quite likely that, ceteris paribus, a significant portion of the rupee liquidity created on account of the additional capital flows get neutralized by rise in currency in circulation; thereby leaving a much lesser residue for RBI to mop up via OMO sales (note: next financial year may start with a much lower level of core liquidity than currently owing to pending currency leakage for the rest of the year).

In light of these factors, we have shifted our overweight stance (> 60% of portfolio) in our active duration funds to 9 – 14 year government bonds from the 5 – 6 year space that we had been liking thus far. With relative more comfort on bond supply absorption, and consistent with our view that policy rates have likely peaked in India, we find risk-reward as favorable with a medium term view in mind. Risks to the strategy include a continued rise in global bond yields as well as any meaningful fiscal slippage locally.

Source: Bandhan MF research



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