A market with attractive investment characteristics
Indian government bonds are investment grade quality (rated Baa3 by Moody’s), yet they still manage to provide very high levels of absolute and relative yields. 10-year government bonds are trading at 7.7% (as of 15 January 2015), which is significantly higher than developed market bond yields, and even compares favourably to emerging market bond yields.
Selected 10 year government bond yields
Source: Bloomberg, as of 15 January 2015
Its flat yield curve is also another attractive characteristic. Yields on the short end of the curve are almost equally high. This means that we can reap the high levels of yield in the market, irrespective of our duration view.
India government bond yield curve
Source: Bloomberg, as of 15 January 2015
India fixed income to benefit from the current supportive macroeconomic environment
Not only does the market continue to boast the above favourable characteristics, but we also see a very positive macroeconomic backdrop for Indian fixed income.
Reform-minded government with decisive mandate to implement measures
We have already seen the new government under PM Modi implementing reform measures to improve the Indian economy. Among this is its commitment to fiscal consolidation, which should lead to further supply side improvements in the bond market. The planned Goods and Services Tax (GST) is a key fiscal reform, which should help increase revenue mobilisation in the medium term.
The fiscal deficit is targeted at 4.1% of GDP in FY14-15, down from the 4.5% in FY13-14 and is projected to narrow further to 3.6% of GDP in FY15-16. There has been increasing concerns that the target for FY15-16 will be missed (and reach 3.8% instead). However, this would be to balance spending and growth, which we don’t see as negative.
The recent plunge in oil prices also bodes well for India fixed income. For one, lower oil prices means the government will be spending less on oil subsidies, leading to further improvement in the fiscal deficit.
Moderating inflation allows central bank to cut interest rates
In the most recent positive development for Indian fixed income, the Reserve Bank of India (RBI) unexpectedly cut rates in January, as a result of faster than expected fall in food inflation, sharp fall in commodity and oil prices, weak demand conditions and the government’s reiteration of its commitment to the fiscal deficit target.
Stubbornly high inflation was a big challenge for India in the past, but inflation moderated significantly in 2014, thanks to the RBI’s anti-inflation policy credibility and lower oil prices.
Inflation in India
Source: Bloomberg, as of end December 2014
We expect the RBI to next move on rates after the Feb-end budget, once it’s clear on the government’s fiscal consolidation plan. Our expectation is for a further 50bps in rate cuts. Any further cuts from there will depend on inflation heading below 6% and the timing of Fed rate hikes.
Expect rangebound rupee in the medium term
Currency movement is also an important factor for foreign investors in this market. The currency has reversed its sharp depreciating trend in 2013 and we expect it to trade rangebound over the medium term.
Given that India is a net importer of oil, declines in oil prices is positive for India’s current account, which could slip into positive territory in 1Q15, helped by seasonally stronger exports as well. Overall, we expect the deficit to be lower in FY15-16. At the same time, investment reforms should be positive for FDI and equity capital inflows. These are among the key macroeconomic factors supporting the currency outlook. In addition, as a result of moderating inflation, real rates have gone up, which should imply a move from gold to financial assets in India, providing further domestic support to the Indian rupee.
In the medium term, we expect the Indian rupee to trade in the 60-64/USD range, with RBI expected to replenish reserves at the lower end of that band and maintain currency competitiveness.
Performance of Indian rupee
Source: Bloomberg, as of 21 January 2015
Our strategy
In this environment, our India fixed income strategy is overweight duration through INR government bonds. We have been adding exposure to longer dated bonds of above 15 years. We also continue to like Indian USD denominated corporate bonds, as they offer the best spreads in the offshore investment grade space. On the other hand, apart from the 1-2 year space which offers attractive carry opportunities and selective liquid 5 year bonds as a supplementary duration play, we are underweight in INR corporate bonds.
This commentary was contributed by HSBC Global Asset Management.
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Issued by HSBC Global Asset Management (Hong Kong) Limited
