Unfortunately most Indian retail investors will miss this great Indian Fixed Income party either because most of them have yet to come out of their long standing love affair with bank fixed deposits, or are dazzled by the SENSEX topping 32k this week. And yet what seems to have largely gone unnoticed is that FIIs have quietly pumped in a whopping Rs. 1.05 lakh crores in Indian bonds since January 2017, twice the Rs. 53,000 crores they have invested in Indian equities over the same period.
By Indranil Guha, Co-founder – Finpeg.com
The key highlight of the last one week in the Fixed Income space was the whopping Rs. 9,000 crore ($1.4 billion) investment by Franklin Templeton in Government of India bonds. On the face of it, this is a huge vote of confidence on the likely trajectory of the Indian economy going forward. But slightly below the surface, this also points to the making of a Fixed Income Party that comes only once in a decade or so – if at all.
What Templeton is basically betting on is that there’s room for RBI to bring down rates quite substantially from current levels in the coming months and years. And there’re good reasons to believe that rates can indeed come down substantially from current levels.
India versus other Emerging Markets bond yeilds
The rates that governments pay on their sovereign bonds is indicative of the health of the economy. Better shape the economy is in, lower are the rates the government has to pay on its sovereign bonds. In this backdrop, the Economic Times pointed out something very interesting this week – yields on 10 year Indian government bonds is at 6.46%, while that of Malaysia is just 3.97%. Now in a situation where the Indian economy has emerged as the fastest growing major economy in the world and is enjoying record low inflation, there’s no reason Indian government should have to pay more than one and a half times higher on its sovereign bonds than Malaysian government has to pay on its bonds, given that the Malaysian economy is still to a large extent driven by oil and is reeling under the impact of the collapse in oil prices in the last few years. This just points to the fact that there’s room for Government of India bond yields to come down substantially from current levels.
Government of India bond yields versus US Treasury yields
Such discrepancies exist not just vis-a-vis bond yields of other emerging markets, but even vis-a-vis sovereign bond yields of mature economies such as the US. Consider this – India’s retail inflation rates are just about 2 percentage points above that of the US. To account for this, yields on Indian government bonds should ordinarily be higher than US government bonds by no more than 2 percentage points. And yet what we actually have is that US 10-year bonds yield are currently around 2.3 per cent while Indian paper of similar maturity yield upwards of 6.4%. So that’s about 4 percentage points higher than US. Again this basically points to the fact that yields on 10 year Indian bonds can potentially come down by up to 2 percentage points from current levels.
And this is what Templeton and a host of other savvy FIIs are punting on – a gradual reduction in rates by RBI, which in turn will help bring down the yield of 10 year Government of India bonds. And as seasoned Fixed Income investors might already know, rates set by RBI and debt fund returns move in opposite direction i.e. when RBI reduces rates, returns on debt funds (also called bond funds) goes up. This is the opportunity that Templeton and its likes are chasing. FII inflows into equities get disproportionate coverage. What seems to have largely gone unnoticed is that FIIs have quietly pumped in a whopping Rs. 1.05 lakh crores ($8 billion) in Indian bonds since January 2017. That’s nearly twice of the Rs. 53,000 crores ($16 billion) they’ve invested in Indian equities over the same period (Source: FPI Monitor, NSDL).
How can retail investors make the most of this opportunity
Unfortunately most Indian retail investors investing in Fixed income products will miss this opportunity either because most of them have yet to come out of their long standing love affair with bank fixed deposits, where post tax returns are now almost down to the levels of savings bank interest rates, or are dazzled by the SENSEX topping 32k this week.
On our part, we have been shouting from rooftop for a while now – for those investing in Fixed Income, now is the time to go heavy on longer duration bonds, if you have a horizon of 2-3 years. The inverse relationship between RBI’s rates and debt fund returns that I talked about above is the strongest for longer duration bond funds like UTI Dynamic Bond Fund. They will be the biggest beneficiary of any rate cut by RBI going forward, and their returns will jump the most within the debt fund basket in the event of a rate cut by RBI. UTI Dynamic Bond Fund for example has a Yield to Maturity (YTM) of 7.83% and a modified duration of 6.42 years (Source: Value Research). Ignore the jargon; what this means is that if RBI indeed kick-starts a gradual but sustained rate cut cycle, returns of this fund over the next 2-3 years can potentially exceed its current YTM by at least one percentage point, possibly even more i.e. you could potentially accrue returns of 8.83% (7.83% + 1%) or higher per annum over the next 2-3 years. With indexation benefits, this could mean upwards to 8% post tax returns even for those in the 30% income tax bracket. I hope most readers would agree that’s substantially higher than anything available in the fixed deposit basket.
But the time to act is now. RBI is widely expected to kick-start a gradual reduction of rates from August onwards and once that starts, the potential of this opportunity will progressively start to diminish.
Before concluding, we wish to reiterate for the sake of setting expectations right, invest in the above mentioned fund only if you have a horizon of 2+ years, ideally 3, so that you get indexation benefits. And if you do that, as I mentioned above, there’s rich harvest awaiting over the next 3 year horizon.