Summary

• Bond yields rose once again in late April when the Reserve Bank of India (RBI) shocked the markets by releasing very hawkish minutes from the 4-5 April Monetary Policy Committee (MPC) meeting. On 5 April, RBI had delivered the most dovish policy since Dr. Urjit Patel became governor in 2016.
• RBI’s mixed signals on monetary policy together with rising oil prices led to large capital outflows from India’s financial markets as foreign portfolio investors (FPIs) pulled out US$1.8 billion from debt and US$0.8 billion from equity markets.
• Some relief from high rates is expected in the coming months from the recent RBI decision to allow FPIs to invest in debt securities with less than three years of residual maturities. Inflation is also projected to decline post May 2018, especially if the upcoming monsoon rains are normal.

Market update - Bond yields seesaw

Yields receded from their elevated levels following RBI’s MPC meeting in early April when the central bank issued the most dovish policy stance under its current governor.  In particular, it lowered guidance with respect to inflation. The inflation forecast for the first half of fiscal year 2019 was trimmed by 50 bps to 4.7-5.1%.  The RBI’s tone in the press conference was also very positive. It termed the inflationary impacts of the Seventh Pay Commission mandated salary hikes and vegetable price acceleration as transitory and seasonal.  Within two weeks, however, RBI released minutes of the MPC meeting.  Their unexpectedly hawkish tone with two members on the panel speaking of ‘withdrawal of accommodation’ had an immediate adverse impact on yields. 

A few other factors also contributed to rising yields in April:

• Higher supply of bonds - While the central government’s borrowing program was trimmed by 360 billion INR to 1.44 trillion, the states’ borrowings are set to increase by 494 billion INR to 1.2 trillion in the first quarter of 2019 fiscal year.  Thus the positive impact of a reduction in the issuance of Government of India (GOI) bonds is more than offset by a greater increase in the states’ borrowing plan for the quarter.
• Lower participation of public sector undertaking (PSU) banks - The major holders of both the GOI and state government debt securities are the Scheduled Commercial Banks, particularly State-owned Banks. We do not yet know whether their lower participation is structural in nature given the balance sheet shrinkage of the state-owned banks.
• Rise in US rates - Most emerging market assets will be adversely impacted by the rise in US yields in excess of 3% and the US dollar strength which raises the spectre of fund outflows. India is no exception.

All in all, yield on the benchmark 10-year GOI bond surged once again to 7.77% at end April from the low level of 7.13% immediately following the dovish MPC meeting early in the month.

The 37bps rise in yield on the benchmark 10-year GOI bond in April coupled with only a modest 6bps decline in AAA-rated 10 year corporate bond spread led to a 0.35% reduction in the Fund’s NAV in Indian rupee terms.  Furthermore, the rupee’s 2.27% depreciation against the US dollar meant that the Fund returned -2.61% in USD terms.  The Fund’s year-to-date total returns are -3.70% (USD) and 0.69% (INR). 

Strategy

The Fund is currently structured to benefit from interest rate reductions in the offing for several reasons. First, inflation is set to come down over time, especially if the monsoon season is normal.  Second, the government should start spending in the near future, thereby improving liquidity and hence bond prices.  Third, the decision by the RBI to lift the restriction in place since 2014 that prevented FPIs from investing in GOI and corporate bonds with less than three years in residual maturity.  At the same time, the FPI limit auctions for GOI and corporate bonds have been eliminated in favour of on-line monitoring of limits.  Both are positive for FPI purchases of bonds.