Summary

• Fears of fiscal slippage and impact of rising oil prices on inflation pushed yields upwards for a fourth consecutive month in November. Yield on the benchmark 10-year Government of India (GOI) bond went up by 20bps and brought the total increase since end-July to nearly 60bps.
• Neither the Moody’s upgrade of India’s sovereign credit rating to Baa2 nor the abrupt cancellation of the planned open market sale of GOI securities proved adequate to boost market sentiment in a sustained manner.

• The Fund gained 0.35% in November despite the sharp rise in yields on GOI bonds because robust foreign capital inflows led to a 45bps appreciation of the Indian rupee against the US dollar.

Market update - Yields continue to rise

Bearish sentiment persisted in the bond market throughout November as demand for bonds weakened, but supply continued to rise. First, retail inflation (CPI) for the month of October increased to 3.6% from 3.3% in the previous month due to rise in food, fuel and housing rent allowance components. Second, increase in global oil prices triggered fears of inflation rising further. Finally, the resumption in government spending in October following two months of belt tightening pushed fiscal deficit to 96% of the budgeted level and raised concerns about fiscal slippage. The sentiment became so bearish towards the middle of November that the benchmark 10-year GOI bond yield breached 7%.

Against this backdrop, Moody's Investors Service upgraded the Government of India's sovereign credit rating to Baa2 from Baa3on 16 November. Moody’s cited India’s progress in implementing a wide-ranging program of economic and institutional reforms whose key elements include:

• The recently-introduced Goods and Services Tax (GST) which will, among other things, promote productivity by removing barriers to interstate trade;
• Improvements to the monetary policy framework via the inflation targeting regime;
• Measures to address the overhang of non-performing loans in the banking system; and
• Measures such as demonetisation, the Aadhaar system of biometric accounts and targeted delivery of benefits through the Direct Benefit Transfer system intended to cut out middlemen and corruption. 

Immediately following the rating upgrade, yields fell by 12bps to 6.94%. The pessimism among investors was so overpowering, however, that the markets could not sustain the rally. In a rare move, the Reserve Bank of India (RBI) cancelled a sale GOI bonds via open market operations (OMOs) worth INR100bn, scheduled for the following week. This improved the market sentiment and yields fell by nearly 16bps, the biggest fall in a year. However, this respite too proved short-lived and yields quickly began to climb above 7% once again.    

GDP data, which was released on 1 December, showed that India’s GDP growth increased to 6.3% in the September quarter, up from a three-year low of 5.7% in the June quarter. Manufacturing activity, in particular, accelerated due to restocking of inventories by companies after the temporary disruption caused by the implementation of the GST. This GDP print is the last key data point available to the RBI before its policy meeting on 6 December. Given the backdrop of growth recovery, rising headline inflation, and potential upside risks to inflation outlook, RBI is likely to keep rates on hold and maintain a neutral policy stance.

Performance

The negative impact of the 20bps rise in yield was greatly offset by the upwards of 10bps tightening of spread on corporate bonds and the Fund’s NAV in INR fell by 10bps. Furthermore, the rupee appreciated by 45bps against the US dollar thanks to the influx of portfolio investments in the equity markets of a little over US$3bn. As a result, the Fund returned 35bp in US dollar terms. 

Strategy

The Fund’s trading activity in November was aimed at increasing its allocation to corporate bonds so as to earn an additional spread and also at cutting duration in the twin beliefs that the policy rate reduction cycle is drawing to a close and the risks of yield curve steepening have risen as the GOI steps up issuance of typically long duration bank recapitalisation bonds.