Who’s afraid of Janet Yellen?

For Indian investors who are tempted to buy long-term gilt funds or income funds for their high return potential, what’s the risk of the US Fed upsetting the apple cart?

Quite a few investors may have nasty memories of the great Indian bond shock of June-August 2013. In that fateful quarter, Fed Chairman Ben Bernanke’s statement about ending the US quantitative easing programme sent ripples of shock through bond and currency markets across the world. In the ‘taper tantrum’ that followed, India saw $13 billion or so of FPI pullouts from the bond market, the rupee slid all the way from 63 to 68/dollar and the RBI panicked to hike its short-term rates by 200 basis points. The immediate spike in market interest rates caused leading gilt funds, which were coasting along on rate cuts, to report a 4-5 per cent NAV loss in a single quarter. Income funds, too, lost 2-3 per cent.

But the impending US Fed rate hike this year may not trigger an equally violent reaction, assert bond managers. For one, India’s fundamentals on the trade deficit and the rupee are today in far better shape than they were in mid-2013 - when we seemed to be hovering on the brink of a balance of payments crisis.

Two, the Fed has been far more careful this time around to telegraph its actions ahead of the event. It is likely to take a gradualist approach to rate hikes. Three, with Indian bonds likely to offer 5-6 per cent more than developed market bonds on a nominal basis after Fed’s rate actions, the differential may lure foreign investors. (A lower cushion may be available on real rates).

“No one expects US policy rates to be normalised very sharply. They would be mindful of the fact that it will have a global impact. I think the impact should be far less than what we saw in 2013,” says Rajeev Radhakrishnan of SBI Mutual Fund. He adds that the RBI has been careful to manage the quality of incremental FPI flows into Indian bonds. “The RBI has been resisting any increase in FPI limits in G-Secs. Restrictions have also been put in to prevent purchases of corporate bonds of less than three-year residual maturity. Earlier, there was a lot of short-term money flowing in from hedge funds, prop books and so on. There was a flourishing carry trade, too. But with these changes, the incremental quality of FPI flows has been better.”

Rahul Goswami of ICICI Prudential believes that given India’s strong macros, the impact is likely to be purely sentimental. “Globally, bond yield levels are so low. German bund yields, after the spike, are just 1 per cent. We are at 7 per cent plus. So, what are we talking about? Global central banks have also been aggressively cutting rates, while our central bank is behind the curve on monetary easing.”

The RBI has also been actively adding to its forex reserves to meet any such contingency. As Akhil Mittal of Tata Mutual Fund explains, “In July 2013, we held $275 billion or so in reserves and faced $13 billion of FPI outflows. Our import cover fell to below seven months. We were swimming naked when the tide turned. Today, even if $13 billion goes out, our reserves are close to $350 billion. The RBI can easily write out that cheque.”

What lends credence to this view is the muted reaction of the Indian bond and currency markets to the global bond rout. The rebound in crude oil prices from $40/barrel to about $60 caused both European and US bond yields to react in a knee-jerk fashion since May. That has triggered foreign fund pullouts and caused currencies to depreciate as well.

But market players point out that India has come out of this episode very well so far. “India has outperformed quite a bit. We went from 7.75 to 8 per cent on the 10-year gilt. Compare it to Germany where the spike was over 50 basis points. So, if you lost ₹2 in India you lost ₹50 in Germany,” says Mittal of Tata Mutual Fund.

Given these factors, the view is that, even if the US Fed rate hike does cause some FPI pullouts and volatility in the Indian bond market, the impact is likely to prove transient. In fact, if you are a braveheart, you can even use any spike in the 10-year G-Sec yield to 8-9 per cent levels to buy into long-term gilt or income funds.

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