Stars aligned for the Indian bond market
Its remarkable growth has established it as one of the largest and most liquid among high-yielding emerging economies
IN RECENT times, concerns about global economic growth, heightened inflation, the cost of living crises, potential policy missteps, and political instability have heightened market volatility and posed challenges for investors strategising their next moves.
As a result of weakening data in the United States, the Federal Reserve initiated its easing cycle with a significant move in September, implementing a 50-basis-point (bps) cut as it begins to adjust monetary policy towards more neutral settings. However, there are concerns that this action may have been too late, potentially leading to a prolonged slowdown in growth or even a recession, given the lags in policy transmission. Such a scenario could adversely affect risk assets.
Additionally, the polarised political landscape and the unpredictable outcome of the US election further complicate the situation, highlighting the importance of seeking diversifying investments. These should include asset classes with low correlation to global or US markets and lower volatility, such as the Indian bond market.
India stands out as one of the world’s fastest-growing major economies, with an impressive average growth rate of nearly 5.7 per cent over the last decade. Its large population, demographic edge, stable political framework, advancing digitalisation, growing share in global manufacturing, and rising consumption from an expanding middle-income segment all fuel its significant growth trajectory. These dynamics position India on a path to potentially become the world’s third-largest economy in the coming decade.
Distinct from many other developing countries, India’s growth is not heavily dependent on commodities. Its government bond market, primarily utilised for financing the government’s budget deficit, has experienced remarkable growth, establishing it as one of the largest and most liquid markets among high-yielding emerging economies.
With bid-ask spreads ranging from 0.5 to 1 basis point for benchmark tenors and an average daily trading volume of approximately US$5 billion, India’s local bond market is second in size only to China’s, offering a compelling case for diversification.
Stable asset with low correlation to global markets
Based on historical data, domestic Indian government bonds are a compelling option for true diversification, exhibiting low correlation with various markets. This includes crude oil (minus 0.15), global equities (0.25), US Treasuries (0.27), China bonds (0.36), Asian ex-Japan equities (0.45), emerging market (EM) hard currency (0.41), and local currency (0.53) bonds. The distinctive feature of low foreign ownership, which constitutes less than 2 per cent of the overall US$2.5 trillion bond market, further supports this.
Over the past decade, the Indian government bond market has consistently delivered strong returns, outshining many asset classes with a 62 per cent gross return in US dollars by the end of June 2024. This performance surpasses that of Asia ex-Japan equities and EM local currency bonds, which have yielded 56 and minus 6 per cent, respectively, over the same period. Its resilience and capacity to outperform are evident across various timeframes, including the year to date.
This resilience can be attributed to the bond market’s low volatility at around 5 per cent, driven by two primary factors: the low volatility of the Indian rupee and the market’s low foreign ownership. The Indian rupee stands as one of the world’s most stable currencies, with one-month implied volatility reaching a two-decade low of 1.7 per cent by the end of July 2024, even lower than that of the Singdollar at 3.7 per cent.
This stability is bolstered by a decade of reforms, substantial foreign exchange reserves exceeding US$670 billion managed by the Reserve Bank of India (RBI) for maintaining stability, and a current account deficit expected to remain under 1 per cent this year – a notable improvement from over a decade ago. Furthermore, as the Indian economy continues to open up, record levels of foreign direct investment inflows are providing additional support to the currency.
Reforms in India play a pivotal role in shaping highly favourable supply and demand dynamics within the bond market. Initiatives such as the Goods and Services Tax (GST), coupled with efforts to curtail subsidies and leakage, have notably bolstered the government’s fiscal stance.
Furthermore, the RBI announced a significant increase in its profit-sharing transfer to the government, thereby providing a substantial fiscal cushion. Consequently, the post-election budget target was ambitiously set at 4.9 per cent of gross domestic product, signalling a decrease in bond supply.
From a valuation standpoint, Indian bonds represent an attractive proposition. As one of the few investment grade assets offering yields of around 7 per cent, they provide an appealing entry point for client portfolios. This is particularly noteworthy given that the yields exceed both the Indian policy rate of 6.5 per cent and the latest inflation figure of 5.1 per cent.
With inflation on a downward trajectory, and the RBI anticipated to ease policy by 50 to 100 bps over the next 12 to 18 months, bondholders could see capital gains.
Further buoying the asset class is S&P’s recent upgrade of India’s outlook from “stable” to “positive”, acknowledging the country’s strong growth and fiscal consolidation efforts. This enhancement suggests that India’s BBB- credit rating could be poised for a well-deserved upgrade.
Inflows from global index inclusions
The inclusion of Indian government debt in global indices marks another significant pillar of support. In 2023, JP Morgan announced the forthcoming inclusion of India in its GBI-EM global index suite, starting in June this year. Upon completion of the inclusion process, India is set to constitute 10 per cent of the index.
This move is anticipated to channel approximately US$30 billion from passive funds into the market, a figure that could further increase as global investors potentially adjust their portfolios to overweight positions in Indian bonds.
The optimism surrounding India and its bond market transcends the mere fact of index inclusion. This enthusiasm is a key reason why index providers are intensifying their focus and accelerating their plans for inclusion.
Indeed, the inclusion in the JP Morgan GBI-EM index might be just the opening chapter of India’s narrative in terms of with global index inclusions.
Bloomberg is currently evaluating the possibility of adding Indian government debt to its global index. While India’s inclusion in Bloomberg’s own EM local currency index has been confirmed, its potential addition to the Global Aggregate index, which is tracked by a broader array of global clients and represents approximately US$4 trillion, would constitute a significantly more impactful development.
The writer is head of Asian sovereign debt, abrdn Investments
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