Our view remains that Indian bonds, particularly government bonds, are attractively poised given that this juncture represents an intersection of structural bullish factors for India and a global top in interest rates. We have recently noted (https://bandhanmutual.com/article/17365) that given this dynamic, investors should aim for optimizing duration on portfolios. Since then signs of further growth weakening, particularly in US and China, have picked up. On the one hand this has led to picking up in rate cut expectations in the US thereby leading to further fall in yields and dollar weakening, while on the other, weaker Chinese data and global manufacturing growth appearing to stall again is putting downward pressure on commodity prices. The chart below captures current market pricing of policy rate trajectory in the three large developed markets (DMs).
As can be seen, outside of Japan, market is now pricing in aggressive rate cuts, particularly in the US. While this tends to move around a bit basis incremental data, the direction is now quite clear and has been flagged thus by the Fed Chair as well. With the ‘all clear’ sounded, one can now look forward to foreign portfolio investors (FPIs) stepping up allocation to other markets as well. Indeed, there is already evidence of this happening. The following chart is notable, in this context:
There are two noteworthy observations here:
One, in some of the hitherto favored EMs like Indonesia, FPI participation has fallen over the Fed rate hike cycle. This will presumably start building now with the cycle turning. Obviously, this will also depend upon the individual country level macro narrative. Also, if the base level of US rates is now higher than in the previous cycle, the ultimate peak allocation may turn out to be lower than before. However, even accounting for that, there seems to be enough room for additional allocations over the next few years.
Two, India is just starting to be discovered from FPI allocation perspective and the scope here is massive. We are the fifth largest market GDP, soon to be third, and one of the best macro narratives for this size. One should expect meaningful India bond allocations to start building now as well. The next couple of years seem particularly well placed for this given the global rate backdrop, starting level of India exposure, and the macro narrative that we present, even as the government and RBI may want to pace the buildup over time.
Having examined the government bond demand environment, let’s now briefly turn to supply. The table below projects net government bond supply assuming next year’s fiscal deficit at 4.4% and a 1% reduction in central government debt to GDP from FY27. To recall, that is the indicated framework from the government even as the assumption of 1% annual reduction is our own.
As can be seen from the table, the net central government bond supply growth is actually negative this year and next and from there rises at or below nominal GDP growth levels. With the global cycle turning, FPI allocations stepping up, and net supply growth negative during this period, the next year and a half seem exceptionally well poised for government bonds. Even after that, while net supply growth picks up it is likely to lag growth in other aggregates like bank deposits. One word of caution though: states also need to maintain some fiscal discipline for overall bond supply environment to remain favorable. Otherwise, while SDL spreads will widen, eventually this supply may also start weighing on local demand for central government bonds.
Bonds Are Cheap
With the above context of demand vs supply of government bonds, we now present some observations on bond valuation:
1. Distance from repo rate: At the time of writing, the 10 year government bond yield is roughly 35 bps higher than the repo rate. This gap should represent uncertainty on policy rate as well as on demand vs supply. However, hardly anyone doubts that policy rate will be cut in the quarters ahead, even as people debate the magnitude and timing of the cuts. Additionally, as discussed above, the demand vs supply equation is exceptionally favorable thereby not requiring much of ‘supply discount’. Thus, there is ample room for the 10 year yield to fall even ahead of the first rate cut from RBI.
2. Real Positive Yield: Granted that this is a bit of a nebulous concept in the absence of market traded inflation expectations. Nevertheless, given RBI’s credibility on inflation targeting and the government’s proactive approach on fiscal as well as supply side management, most forecasters will be happy assuming around 4.5% as medium term inflation. Even from this standpoint, there is more than enough room for nominal yields to fall. It is to be noted that this discussion is in the here and now context: over time we expect real yields to compress much further given the other factors as discussed above.
Summary and Conclusion
1. The current juncture is exceptionally attractive for Indian bonds given that it represents structural tailwinds coinciding with a global rate cycle peak.
2. The demand vs supply equation is particularly attractive for government bonds. This may be somewhat underappreciated currently given the still lingering backdrop of ‘oversupply’ in the pandemic response years. This scenario has now completely turned on its head, with the government adopting a rigorous consolidation path. For that reason any historic spread analysis when forming a view is virtually meaningless.
3. Real money investors should focus on building appropriate duration with preference for government bonds, in our view. The corporate bond curve is inverted given pressures from credit – deposit ratio at the front end. This is allowing for a good opportunity to build ‘carry’ income from short – medium duration corporate bonds and money market instruments, while focussing on building duration via government bonds. We are using this strategy in a host of our short / intermediate duration products.
4. Government bonds are cheap in our view, and investors should aim to capitalise on this opportunity.
Source: RBI and Bandhan internal research
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