Why this appetite for Indian bonds?

“In finance, everything that is agreeable is unsound and everything that is sound is disagreeable.” When former British prime minister Winston Churchill made this statement, he would not have imagined that it would apply to some of his own economic decisions.

But, it did. For example, in his later years Churchill regretted his decision to take Britain back to the gold standard in the mid-1920s and saw it as the greatest mistake of his life. (Combined with the US’ strict adherence to the gold-based monetary standard in the 1920s, the deflationary bias inherent in that arrangement has been identified as the single major economic cause of the Great Depression.)

Churchill’s decision was generally popular and agreeable when it was implemented. The dissenting views, led by John Maynard Keynes, were found disagreeable. But in retrospect, that was recognised as “sound economics”.

To be sure, Churchill’s statement is no iron law. One cannot infer that the contrary or dissenting view will always turn out to be sound in the end.

What the statement actually highlights is herdlike behaviour in the economics and finance world. When a trend is in place, it is difficult to avoid it and one is willy-nilly co-opted into it. The alternative view is generally ignored.

Though the alternative need not be taken as the truth straightaway, it should at least not be ignored. That is the larger message from the Churchill experience.

It is with this message in mind that one studies foreign investment behaviour and the trajectory of yield movements in Indian government bonds alongside the Indian rupee’s performance in the last few years. This study shows that herdlike behaviour continues to be alive and kicking, nearly 100 years after Churchill’s decision on the UK’s reversion to the gold standard.

Habits die hard and more so in financial markets, it seems.

How else can you describe a situation where foreign portfolio investors (FPI) get paltry returns of 0.5 per cent on Government of India (GoI) bonds and not much higher returns of 1.5 per cent on Indian corporate bonds — after adjusting for currency depreciation — but still invest in droves in Indian bonds?

As the table shows, FPI in Indian debt has held up quite well, despite the Indian rupee’s precipitous fall in the five years from 2011-12 — down a cumulative 35 per cent on a financial year average basis — and the resultant drag on final investment returns. NSDL data show 85 per cent utilisation of the limits allowed for FPI investments in government debt and 66 per cent utilisation in private corporate debt. (Though net FPI investment in debt so far in FY2017 has been muted, we have so far not seen any sustained withdrawal from Indian markets.)

Adjusting for the fall in the rupee, an investment made in GoI debt in 2011-12 at the financial year average yield of 8.45 per cent would yield final net returns of just about 0.5 per cent in dollar terms when the investment matured in 2016. (Foreign investment in Indian debt is primarily concentrated in the (residual) maturity bucket up to 5 years, as per official data.)

Even with a spread of 200-300 basis points over GoI, the net return on AAA private corporate debt for an FPI in the last five years works out to only 1.6-1.7 per cent. As for the record investment of nearly ₹1,70,000 crore in 2014-15 at an average exchange rate of ₹61 to the dollar, the story is the same. Note that the rupee is down nearly 10 per cent since 2014-15.

So, where is the yield pick-up?

What can explain this almost irrational flow of foreign investments into Indian debt (and more generally emerging market debt) when the investment experience has not been fruitful?

Obviously, there is quite some long-term investment money — from the likes of pension and annuity vehicles in the advanced economies — that is flowing in.

It is well known that in many OECD countries, annuities have been promised assuming much higher interest rates (at least 5 to 6 per cent on long-term bonds and central bank short-term reference rates around 2 per cent) would prevail over the life term of the annuities.

But, in the ultra-low interest rate environment now, these long-term investors have been forced to seek higher yields in emerging markets across the world.

Ultra-low and even negative yields have been around in Japan for quite some time now. The recent entrant into this zone of negative yields is Germany. It is estimated that these two countries together have about $10 trillion of bonds in negative yield territory.

Yields are below 1 per cent for all maturities up to five years even in the US, and 10-year and 30-year yields are at historic lows.

The market also seems to be discounting the prospect of immediate interest rate increases in the US and even if rate hike(s) come, its magnitude is expected to be small.

Given this backdrop, it is not surprising that herds of portfolio investors are being pushed into investing in emerging market debt such as India’s.

Given India’s overall economic performance and the steep value loss in currency, it cannot be the case that India is pulling investments in — by virtue of its superior prospects.

The fact that it is more push (herded) into India rather than being pulled into India should caution all market participants — be they in debt markets or in other financial markets such as foreign exchange.

Triggers for reversal of these flows could come from many sources — economic or geo-political. Shocks could emanate from many fragile economies such as the Euro Zone or China, setting off risk-averse capital outflows.

Geo-political risks are also probably being seriously underestimated by market participants now. Also to be noted is that FPIs may have to act in a self-fulfilling manner if their investment decisions have to come out winners.

Unless you put more money, you face higher local currency risk. That can be a vicious circle and not really supportive of overall market stability.

The writer is a Chennai-based financial consultant

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