Indian Sovereign Bond: The Post Index Inclusion Outlook

Kate Lin:  Welcome to Morningstar. JP Morgan has included India's sovereign debt in its emerging market index, a move that is expected to drive billions of dollars in passive flows into rupee-denominated debt. What do active managers think about the inclusion? With China slowing down and Russia being out, should investors look again at the EM sovereign space? We're asking Kenneth Akintewe, head of Asian sovereign debt at Abrdn.

Hi Kenneth. What does India's inclusion in the sovereign debt index mean for investors and how does it impact the index dynamics and the attractiveness of the asset class?

'The Mistake Would Be to Think the Opportunity is Index Inclusion'

Kenneth Akintewe: It's an interesting question. You can look at it from a few perspectives. The fact that we're having this call today, maybe the most beneficial thing is that index inclusion actually wakes up investors to the opportunity in the Indian market. The mistake would be to think that the opportunity is because of index inclusion. This is not a new market. We've been investing in India for well over 10 years.

And for those investors that have been engaged, they will understand the power of this market. It helps you to build much stronger portfolios. It's a very idiosyncratic market, right. It has delivered some of the strongest performance over the last decade that we've seen in any market, not just against the bond markets.

If you're looking over the last 10 years, at the end of September, the return of local currency India bond market in U.S. dollar terms, so including currency risk was over 70%. So that outperforms the global equity market, certainly outperforms Asian and EM equity markets.

Hopefully, index inclusion means that investors will begin to look at this market more closely and understand how you can fit it into global bond portfolios, EM bond portfolios, and multi-asset portfolios. And by doing that, you can lower the volatility and risk of these portfolios, make them more resilient, and improve the actual return that they get.

In terms of the impact on the index, one thing you have to understand is the reason the index companies are wanting to put India, following on from China obviously into the indices, is because, in an EM index, there are many markets that have been subjected to a substantial risk. Obviously, the obvious ones were Argentina, and Russia. We've seen a tremendous amount of volatility in Turkey. And, at a certain point, those allocations become challenging to allocate to too high volatility and the returns not compelling.

Over the last decade the returns from EM local currency were actually negative. So you can imagine what putting a market like India into that index does. It improves the quality of the index. It's an investment-grade market and country. So that is one of the benefits to investors that do allocate to EM. You will see, as China and India are included there – they have low correlations, and they were less than rest of the other markets in the index. It will create an index that is a little bit more resilient, a little bit less volatile, and hopefully, generates a stronger performance.

The Source of Inflation in India Is Different

Lin: after the relatively strong performance you just mentioned, what are the fundamentals of Indian sovereign debt like right now?

Akintewe: The fundamentals are pretty strong. I mean this is where it starts to differ with maybe the comparable market would be like China. China also was one of the top performing markets and was a really important market to hold, through the COVID crisis. And it follows its own cycle as other markets have gone through their inflation cycles. Obviously, growth has been weak in China and rates have come down and that's where they kind of diverge.

Because in India, similar to other markets, it's been going through its inflation cycle. The central bank has had to hike policy interest rates. So yields are generally quite high at the moment. Now the peak in the inflation cycle was actually last year, to be specific, April of 2022. Since then, inflation has been coming down and the central bank has been able to pause in its hiking cycle. And as we look forward, that's where things start to become interesting.

Now the inflation in India is a little bit different from if you're looking at inflation say in the U.S. which has been domestic demand driven. India has experienced an inflation shock driven by elevated food prices. The first stage of it came from after the conflict in Ukraine and Russia, which obviously led to a spike in things like edible oils and food prices. But more recently adverse weather conditions caused by some unseasonably hot weather in South Asia generally impact the agricultural sector. Now importantly, we're already seeing that correcting. There's been a substantial decline in food prices in September. We're expecting September inflation to be between sort of 5 to 5.5%, from the close to 7% levels that we've been at recently. And as we look beyond that, we're actually starting to see the monetary policy is having traction so what I mean by that is core inflation is already coming down. As we look into next year, we potentially will be seeing during the course of the first half year, inflation starting to get down to maybe 4.5% levels.

What that obviously means in an environment, which is likely to be characterized by maybe growth headwinds, is that the central bank doesn't need to keep policy rates where they are. And we expect the RBI in the course of 2024 to be cutting the policy rates by anywhere from 50 to 100 basis points. That will obviously cause bond yields to come down. You have the opportunity for capital gains on top of the very attractive yields that you get in this market. The yield is slightly above 7% on average.

Now an important factor for this market and why it's different from many other bond markets is the currency risk, because when you buy local currency debt by default you get exposure to the currency. And the problem for many emerging markets and even G10 local currency bonds is currency volatility is high. Like in G10 currencies, you could be talking about 10 to 13% volatility. In EM, it's more like 15 to 20%. So while you get high yields, those returns from the bonds can be wiped out by currency depreciation. The rupee has one of the lowest volatilities of any global currency. More recently it's been less than 3.5% in terms of its one-month implied volatility. That's exceptionally low, and that's not a fluke. It's by design. The central bank manages volatility and it has some of the highest reserves in the world to do that, almost $600 billion. And, it actively uses those reserves to intervene to ensure that the volatility of the rupee is not too high.

I would also add in terms of fundamentals is that India is one of the strongest reform stories over the last decade that you've seen and will continue to be. It's a very reformed environment where we've seen reforms that were decades in the making finally beginning to materialize. It has impacts for a monetary policy where you've got a central bank that now has an inflation-targeting framework. The tax reforms, like GST, have supported improvements in the tax environment. And all this is extremely important not just for the economy but the markets themselves.

In terms of the fundamentals, we have things like the opening of the economy to investments, and some of the strongest foreign direct investment growth which is supportive of the currency. All these things are all coming together to create an environment that is very beneficial to the market and economy.

What Are Abrdn's Portfolios Buying?

Lin: Let's move our conversation to portfolios. With China's growth slowing and Russia being under sanction, what are EM sovereign portfolios buying right now?

Akintewe: Yeah, so there's actually been a number of trades that have looked pretty favorable, I'd say. In the broader EM markets, these are actually some of the markets and economies, where we saw inflation cycles peak first and we saw some of the first central banks actually cutting interest rates.

In Asia, central banks haven't been able to cut interest rates yet, even though the backdrop actually would be favorable to do so. So there's been less of an inflation problem in Asia. Some countries like Korea, for example, inflation is already back at 2%, same in Indonesia. But the reason the central banks don't want to cut interest rates is if you have too much of an interest rate differential with the U.S. growing, you start to put undue pressure on your currency. So that's kind of holding them back.

In the broader EM markets, which experienced far more of an inflation shock, the result in central banks having to hike far more aggressively. Central banks like the central bank in Brazil have already been able to cut the policy rate by 100 basis points. So we've seen really good opportunities in those markets as the cycles peak there in places like Mexico, Brazil, and Colombia. These are some of the markets that we favored as cycles peaked to actually have overweight positions in the bond markets. The other key difference there is the environment was also supported to some of the stronger performance from currencies, EM currencies that we've seen.

In the Asian portfolios, to be honest, we're actually in a in a relatively good environment. I mean one has to bear in mind that we went through a long period of time of dealing with uncharacteristically low interest rates. Investors were complaining that they didn't get paid to hold bonds and now we've gone through a really aggressive interest rate cycle that has taken rates across many markets. The levels were finally, you get paid for actually holding interest rate-bearing instruments. T-bill markets in Singapore, you earn 4% on those, without even any duration risk. But, as cycles peak, there's an argument for starting to take duration with your bond trade. So there's actually a number of markets we like from Korea to Indonesia.

India is one of our biggest risk positions, because of its resilience that we think could potentially do well over the coming sort of 12 to 18 months as we start to see these inflation and monetary policy cycles roll over and the central banks finally get into a position where they can actually start thinking about cutting interest rates.

Investors Should Be Mindful of Currency Risk

Lin: on the other hand, are there any markets that you would advise caution against?

Akintewe: Yeah, I mean there are still those markets that will be more sensitive to the last phase of monetary policy cycles. A lot of uncertainty as to if the U.S. Fed’s interest rate cycle has peaked, and even if it hasn't, how much more pressure we may see for example on the 10 year or longer part of the curve which is still inverted.

Now some of the markets in Asia have pretty high correlations to the U.S. treasury market. The obvious one would be Hong Kong due to the Hong Kong dollar peg. So these markets we've still generally been a bit cautious, generally prefer to be short duration or underweight the bond markets to avoid any residual sort of upward pressure on interest rates for the time being. We think opportunities even those markets will come later on.

I'll say the main thing that we're being cautious about is currency risk. Again currency volatility even if lower in Asia still is what will more impact the performance of a portfolio. And with the dollar still having been seeing pretty strong momentum, we've generally favored more relative value trades in the portfolio, rather than taking directional risk against the U.S. dollar. And so we prefer to fund some of the overweight positions that we have, for example in the Indian rupee, in the Indonesian rupiah, with underweights to currencies like for example the Chinese yuan. Obviously, it's fairly cheap to fund out of the Chinese Yuan due to the relative interest rates and we've seen negative pressure on the currency as well. So by doing that, we can lower the volatility of portfolios and also manage the risk against the US dollar. And for the time being, we would also advise to be a little bit cautious when it comes to currency risk. And maybe as we get into next year when it's more obvious that the U.S. cycle is peaking, you'll be able to then shift into more short dollar positions in portfolios.

Lin: Wonderful. Thank you so much for joining us, Kenneth. For Morningstar, I am Kate Lin.