Our view remains that Indian bonds are experiencing strong tailwinds which are a combination of short term (cyclical) and medium term (structural) factors. This seems to us a somewhat unique set up in comparison to our own recent market history. The fall in yields so far is nowhere close to pricing in the full effects of this, in our very strong view. Below we summarize again the framework for Indian bonds, as we see it:
1. A solid macro narrative: India’s current account and fiscal deficits have seen an impressive compression over the past few years. Importantly, these are not all cyclical compression. Our monthly services trade surplus run rate has moved up from USD 6 – 8 billion a few years back to USD 12 – 15 billion now. This reflects the strong growth in services onshoring for India and isn’t a cyclical phenomenon, even as a cycle slowdown in the West may lead to some temporary slowdown here. Rather it reflects a growing footprint of global capability centers (GCCs), a trend that is expected to continue strengthening in the future. This has cut 1 - 1.5% from the headline current account deficit, ceteris paribus.
Turn to fiscal deficit, where the current phase of compression is without extra-ordinarily strong nominal GDP growth, aggressive divestments, or below the line financing. Instead, most of the compression is owing to better tax buoyancy (greater formalization, and the so called ‘J’ curve effect on indirect taxes post GST reform stabilizing) and judicious expenditure management. There are elements of cyclicality here as well, but that is not all of it. Further, the central government has shown impressive commitment towards fiscal consolidation and is moving towards a framework-based approach that seems more sustainable over the medium term. While state finances definitely bear watching, the direction of travel for general government deficit seems clear.
Finally, the RBI over the past few years has proven itself to have had an unwavering focus on overall financial stability. This includes not just its commitment to inflation targeting, but also approach to reserve management, timely interventions with macro-prudential tools etc. This has strengthened confidence that the central bank will generally preserve the value of the currency and ensure that changes in either direction are orderly. In turn, this confidence is very important to global investors when they allocate serious flows to India.
It is to be noted that these positives are in context of the de-facto AAA of the world, the US economy, running approximately a 6 - 7% fiscal deficit and a 3% current account deficit. This argues for some narrowing of rating differentials of India vs US over the medium term, with narrower bond yield differentials overtime as well.
2. Rising long term local participation: Over the past few years, the share of long-term investors in India’s government bond market has risen at an impressive pace. While there may be temporary pauses / setbacks from time to time, this phenomenon also seems structural rather than cyclical as the trend is for larger parts of the population to get formal coverage. The chart below shows the rising heft of this segment.
This has lent more stability to the market and allowed the government to increase average maturity of its borrowing, thereby cutting any future potential refinancing risks. For investors this means that the yield curve will probably remain flatter than in earlier periods and investing in long duration bonds is no longer as exotic an exercise as it was once thought to be. This also represents a more direct way of channeling retail savings into the bond market, than via the bank deposit route.
3. FPI discovery of Indian bonds: Global institutional investors have been largely dormant for a long period in Indian fixed income. This phase has finally turned since last year and, in our view, is likely to run for some time.
Thus, while the proximate trigger has been the JP Morgan bond index inclusion, we believe this was only the necessary nudge required for global institutional investors to look at India participation more actively. The very recent FTSE Russell indices inclusions are also a hat tip to India bonds becoming mainstream in institutional investor portfolios. Combined with the macro narrative and the size of India’s market and the economy (again, the latter is not cyclical), we expect FPI ownership to keep expanding over the next few years. The chart below shows how under-owned India is versus a lot of other markets.
Bonds Are Still Cheap
Indian bonds today have a strong narrative, rising retail participation via the insurance/ pension channel, and FPI steadily increasing ownership. Equity investors will find this set-up familiar, including what it potentially brings: a rise in asset class valuation. In the context of fixed income valuation enhancement may mean continued low term spreads (or relatively flat yield curves) and lower real yields over time.
That said, the short-term factors are also positive: One, net government bond supply rise is negative this year and next when a substantial chunk of FPI participation is expected as the global monetary policy cycle turns. Two, RBI’s easing may be more modest but it's nevertheless coming. Given all of this, most of the sovereign bond curve yields are still comfortably over the repo rate. We reiterate the following:
1. Bonds, especially sovereign bonds, are cheap and investors should have a healthy allocation to them in their fixed income portfolios.
2. The biggest risk facing investors is reinvestment risk and this needs to be mitigated via appropriate duration selection.
Source: RBI and Bandhan internal research
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