Summary

• Bond yields continued to fall through the month of July.  The benchmark ten-year yield on the Government of India (GOI) bond fell to 6.41% on 24 July from the peak of 6.56% on 3 July. Profit-taking led to some rise in yield by the month’s end.
• Another sharp decline in inflation and the satisfactory progress of monsoon rains continued to fuel expectations of a rate cut in the 2 August Monetary Policy Committee meeting. 
• Robust capital flows from Foreign Portfolio Investors (FPI) contributed to a 76bps appreciation of the Indian rupee against the US dollar.  Furthermore, FPI holdings of corporate bonds reached 95% of the prescribed limit and resulted in the auction of corporate bond limit, the first since March 2013.

Market update - softer yields

Several factors supported market expectations of falling yields on Indian bonds:

• June consumer price inflation (CPI) eased to a fresh low of 1.5% year on year (YOY) from 2.2% in May, mainly due to fall in housing and fuel prices.
• More importantly, core inflation (ex-food & energy) also moderated to 3.9% in June from 4.3% in May.
• The monsoon’s satisfactory progress to date, with rainfall 4% above normal by the end of July, was also helpful in further tamping down near-term inflation expectations. Good spatial distribution was yet another positive with 91.6% of the cropped area receiving normal to above normal rains.
• With CPI reaching a five-year low and a steep fall in core inflation, market expectation of a rate cut in the upcoming monetary policy meeting on 2 August have strengthened. 
• Indian bond markets also reacted to the falling yields on US treasury bills.  The Senate’s failure to repeal and replace the Affordable Care Act (Obamacare) added to concerns about the Trump administration’s ability deliver on its pro-growth agenda, thereby diminishing the prospects of a Fed rate hike.

Favorable supply-demand dynamics also helped sustain the positive bond market momentum.  The net issuance of GOI bonds was set to fall sharply to INR4bn in July from INR600bn in June in an environment of robust demand from domestic and foreign institutional investors.  Indeed, FPIs poured US$2.9bn in India’s debt markets in July. The stepped-up FPI demand for corporate bonds   resulted in their owning in excess of 95% of the INR2.4trn (roughly US$ 37bn) limit on all foreign investment in corporate bonds.  The Securities and Exchange Board conducted a corporate bond limit auction on 26 July.  The cut-off for purchasing limit was 8bps.  The limit auctions will be discontinued only after the utilisation falls below 92%.

Fund activity

The NAV was down 20bps in INR terms.  The portfolio spread increased from 61 to 70 bps in July due to the underperformance of Bajaj Finance, Shriram Transport and Steel Authority of India bonds.   The 76bps rupee appreciation, however, resulted in the Fund returning 56bps in US dollar terms. 

Outlook

The Monetary Policy Committee, which cut the policy interest rate by 25bps to 6% on 2 August, reiterated its neutral stance on monetary policy.  Its baseline inflation trajectory is now tracking a little above 4% by the end of March 2018 and 4.5% including implementation of the Seventh Pay Commission mandated salary and allowance hikes by the central government.  Headline inflation could rise even further if states were to also implement similar increases in salaries and allowances. Hence, another policy rate cut appears unlikely in the coming months.  As a result, the Fund plans to reduce its exposure to the low yielding government bonds while allocating more of its AUM to higher yielding corporate bonds.