The domestic equity markets have been in a corrective mode in recent weeks. But a good part of the reason for this can be attributed more to the action in the bond markets globally — specifically in the US. The Reserve Bank of India’s relatively hawkish take on inflation (and liquidity) in the recent policy meeting — and geopolitical tensions following the Israel-Hamas conflict — have added to the challenges.
These happenings spoilt an otherwise reasonably rosy scenario for the debt markets till a month or so ago, as GDP growth was good, inflation under control and the JP Morgan bond addition served as an icing.
Yields in the US treasuries have risen sharply over the past few months, as have Indian G-Sec yields (government securities) across tenors over the past 8-10 weeks.
What are the implications for fixed income investors? Do high yields present an attractive entry point for the long term?
Read on as we discuss the impact of three key developments — JP Morgan’s India bond addition, record US treasury yield situation and RBI’s hawkish stance & spike in domestic yields — and present investment avenues you can consider for your portfolio.
JP Morgan’s bond addition
At long last, we had a global financial service provider, JP Morgan, announcing the addition of Indian Government Bonds (IGBs) into its Government Bond Index-Emerging Markets (GBI-EM). The index will have only those bonds that are issued by the RBI and are available under the fully accessible route — a channel to enable non-resident investors to invest in Indian government securities.
First, the basic details. The addition will start from June 2024 and continue till March 2025. The weightage in the index will start at 1 per cent in June 2024 and will increase by 1 percentage point till March 2025. Over the 10-month period, IGBs will have a 10 per cent weight in the bond index. at the rate of 1 per cent addition per month
The eligibility set out is those IGBs with at least $1 billion outstanding and having a residual maturity of 2.5 years, which means only bonds maturing after December 2026 are eligible.
Based on these criteria, 23 IGBs worth about $330 billion are eligible for inclusion in the bond index. The JP Morgan bond index has about $213 billion size of investment in total. India’s 10 per cent weight will mean about $21 billion of bonds would be included.
On a base of $330 billion, incremental inflow of $21 billion from Foreign Portfolio Investors (FPIs) is likely to have a positive effect on bond prices and may lower yields.
Given that banks, insurance companies and mutual funds are the main buyers of Indian debt securities, an additional buyer in the form of FPIs would be welcome.
Also, if other index providers such as Bloomberg, S&P and FTSE find merit in adding IGBs to their emerging market indices, it would serve as a fillip to greater FPI flows and deepening of bond markets.
However, dig deeper and it may well be that the bond inclusion is only a marginal positive.
First, the $21 billion inflow mentioned earlier is a one-time affair with the bond index inclusion over a 10-month window (June 2024 to March 2025) since the weightage is capped at 10 per cent. Passive flows into the JP Morgan index would determine periodic rebalancing and result in incremental inflows as well as outflows.
Second, India’s total G-Sec market is valued at $1.2 trillion currently. Therefore, when we now take the $21 billion inflow from FPIs in context, it would hardly move the needle on domestic bond yields.
Third, the yield gap between Indian G-Secs and US Treasuries across tenors is at historic lows (will be explained in the next section). Given the narrow gap and high yields in the US, FPIs are likely to favour investments in the latter, especially as the currency factor would be out of the way. Any serious widening of yield gap — which is quite unlikely in the short to medium term — may bring incremental attraction to Indian bond markets for FPIs, more so for those investing via the active route. As no tax benefits have been extended, there is no added incentive for a bond rush from FPIs.
India will borrow₹15-16 lakh crore or about $198 billion in FY24, and perhaps higher amounts through FY25, adding to the existing pile of G-Secs. , So, the one-time inflow, though expected to give some push for mildly lower yields, has limited chance of creating any serious structural long-term impact on yields for the foreseeable future.
In FY24 thus far, they have net bought ₹31,934 crore of debt in the Indian markets. .
When seen in totality, while the bond index addition is definitely a positive sentimental booster, any serious rally in the bond market (and considerable yield reduction) over the long term on the basis of this move alone, may not materialise that easily.
Roiled US debt markets
Thanks to the record inflation levels in 2022 due to Covid supply chain disruptions, Russia-Ukraine war and easy liquidity, the Federal Reserve has increased interest rates by 525 basis points from near-zero levels beginning mid 2022. It also started the second phase of quantitative tightening that ended a decade-long loose liquidity situation (the first phase was stopped in 2019.) Since June 2022, the Federal Reserve has reportedly reduced its balance sheet by $1 trillion.
In the current year till September, the US budget deficit is $1.695 trillion, up 23 per cent over the previous year. And the government is reportedly asking for another $100 billion for the Russia-Ukraine and Israel-Hamas wars.
Inflation has cooled off steadily from 9.1 per cent in July 2022 to 3.7 per cent by October 2023.
Though there are some conflicting signs like the tight labour market with very low employment and decelerating credit card spends, the last two quarters have seen the US economy grow by 2 per cent and 4.9 per cent. Federal Reserve hopes for a slowing economy — on the back of interest rate hikes and balance sheet reduction — to reduce consumer demand, cool off the labour market and thus bring inflation to 2 per cent levels.
Thus, the Fed remains hawkish. So, yields of many tenors of US treasury securities have risen sharply over the past few quarters .
Since 2021, US 10-year treasury bond yields have risen steadily and are currently at 4.86 per cent (October 26), up from 1.5 per cent levels in October 2021.
The one-year treasury yield is at 5.44 per cent (October 26) per cent from 0.72 per cent in February 2022. Even 2-year and 5-year treasuries trade at 5.05 per cent and 4.8 per cent, respectively. These were levels last seen in 2005-07.
The inverted yield curve where short-term yields are lower than those on longer-term treasuries usually suggests expectations of an economic slowdown.
But even though there may still be another rate hike in the coming quarters, the general expectation is that yields are close to the peak as the interest rate cycle may be close to the top.
One key aspect to note is that the difference in yields of Indian G-Secs and those of their US counterparts for similar tenors has narrowed considerably.
The 10-year G-Sec yield and the 10-year US treasury yield are at 7.4 per cent and 4.86 per cent, respectively, or a gap of only 254 basis points. For perspective, the gap was over 600 basis points in January 2014 and about 500 basis points in September 2020.
Even the interest rate differential — repo rate minus the Fed funds rate — is only about 110 basis points currently. It was 780 basis points in 2014.
Thus, there has been greater attraction towards US bonds in recent times given the higher yields and safe-haven status in a volatile global economic environment.
RBI stance and higher yields in India
To be sure, the RBI last hiked the repo rate in February 2023 and has since maintained a pause in the subsequent four monetary policy meetings. India’s consumer price inflation has been on a consistently downward trajectory over the past one year, barring the odd spike due to vegetable/food price rise.
From the highs of 7.43 per cent in March 2023 after the Silicon Valley Bank collapse and other banking troubles in the US, the 10-year Indian G-Sec fell to 7 per cent levels in May. Over the next four months, the yield inched up to 7.1 per cent.
Even RBI’s directive to banks for having higher incremental cash reserve ratio (ICRR), in its August policy, impacted the yield only a wee bit, though the move sucked out ₹1 lakh crore liquidity from the system.
But the Central Bank’s continuing hawkish stance on inflation, global yield spikes, geopolitical tensions and the indication in the October policy meeting of conducting open market operations (OMO) to absorb excess liquidity sent the 10-year yields north to nudge 7.4 per cent levels.
From the middle of September 2023, the liquidity in the financial system slipped into the negative territory from a surplus situation. Reports suggest that liquidity was in deficit to the tune of ₹1 lakh crore recently. From sub 7 per cent levels, the 182-day and 364-day T-bills now trade at yields of 7.14 per cent and 7.16 per cent, respectively. Thus, the tight liquidity has pushed up yields in the system. The 5-year G-Sec yield is also at 7.36 per cent, 20-25 basis points higher than what it was just a couple of months ago.
For perspective, the 10-year G-Sec had hit a closing high of 7.55 per cent in June 2022 as rate hikes just started.
After a hike of 250 basis points over 2022-23, and as both wholesale and retail inflation are under control, the RBI may continue to remain in pause mode. Though yields could increase a bit in the short term, interest rates may well have touched their peak for the foreseeable future in the country.
What should investors do?
In light of the above discussions, there are several investment opportunities for investors. The bond yield spike at two ends of the curve presents interesting opportunities for fixed income investors.
Short term: As mentioned earlier, the short-term yields on 182-day and 364-day T-bills trade at attractive levels. Therefore, mutual funds that invest in such securities would be gainful for investors. Specifically, money market funds invest in short-term securities.
Investors can consider HDFC Money Market, Aditya Birla Sun Life Money Manager, Nippon India Money Market and SBI Savings. These funds invest in a portfolio with average maturity of 5-6 months and carry yields to maturity of 7.4-7.5 per cent currently. Since taxation occurs only upon sale of units, investors can plan accordingly and lock into these attractive yields.
Medium term: For the medium term, we would prefer highly rated non-convertible debentures (NCDs) that offer good yields for the 3-5 year period. Ensure that you invest only in AAA or AA rated NCDs and consider A rated ones only if there is large reliable conglomerate backing.
Since there aren’t any mutual fund or other avenues offering higher returns or yields in the 3-5-year tenor, NCDs may be preferable.
Currently, we have Piramal Enterprises NCD open and yields north of 9 per cent are available for investors.
From the secondary markets, the NCDs of Aditya Birla Finance and Cholamandalam Finance offer yields of over 8 per cent for 3-5-years, though trading is infrequent and volumes are low thus far, as seen from the exchanges.
These yields can be realised only if held till maturity. Any sale done earlier can alter the yields.
Keep NCD exposures to 5-10 per cent of your overall debt portfolio.
Long term: For investors, especially retirees, looking for regular income and willing to stay locked in for the longer term, direct investment in G-Secs through the RBI’s retail direct platform can be a good option. The G-Secs maturing in 2037 may be considered for a yield of 7.46 per cent, which is higher than what insurance companies offer on annuities. The G-Sec maturing in 2033 with 7.26 per cent and trading at a yield of 7.39 per cent is another option.
Target maturity funds, although out of favour due to the removal indexation and tax benefits, can also be useful additions for goal-based investing.
The Bharat Bond ETF maturing in 2030 offers a yield to maturity of 7.66 per cent. It charges 6 basis points as expenses. Edelweiss CRISIL IBX 50:50 Gilt Plus SDL April 2037 Index fund can be considered for an yield to maturity of 7.68 per cent (October 25). The fund has an expense ratio of 18 basis points. Post-expenses yields will be a wee bit lower.
Another avenue is gilt funds. ICICI Prudential Gilt, Kotak Gilt and SBI Magnum Gilt are suitable choices, given their strong track performance record. The current yields to maturity of these funds go up to 7.67 per cent and average maturities range from 5-10 years (September factsheet data). Since g-secs have been recommended, we are avoiding constant maturity 10-year gilt funds as yields would be lower after fund charges.