abrdn: Why India’s impending bond index inclusion is a big deal

January 13, 2022

In its upcoming budget for 2022-23, which is due to be tabled in February 2022, the Indian government is expected to propose a critical tax exemption for Euroclear settlements. Without getting too technical, essentially the tax change should make it much more practical for Indian sovereign bond trades to be settled via the Euroclear clearinghouse.

Crucially, this will remove the previous key barrier for index inclusion. If the budget (including the key tax amendment) is approved by parliament on time, then the process for Indian bond index inclusion could potentially begin from as early as in March 2022.

Flow impact of index inclusion

Morgan Stanley recently estimated that inclusion in the JP Morgan GBI-EM and Bloomberg Barclays Global Aggregate bond indices would result in one-off inflows of $ 40bn over 2022-23, followed by annual inflows of $ 18.5bn over the next decade. While these sums may sound large, they need to be seen in the context of the comparatively huge-sized $ 1.1trn Indian sovereign bond market.

Indeed, it’s worth noting that even after projected index inflows, Morgan Stanley estimates that the foreign ownership share of Indian sovereign bonds would still amount to a relatively modest 9% by 2031, albeit up from under 2% at present. 

Foreign ownership share (%) of selected central government bonds *

Source:  CEIC, Bloomberg, Morgan Stanley Research; * only includes pure nominal local currency central government bonds, which is a better reflection of foreign ownership. October 2021

 How India would benefit

Despite the fairly modest size of projected inflows relative to market size, increased index presence should offer a number of financial and real economy benefits for India. In terms of the balance of payments, increased foreign bond inflows would support the portfolio investment component. For example, an index–related annual inflow of $ 18.5bn would be equivalent to around +0.7% of GDP of additional balance of payments support. Furthermore, increased index inflows would also provide some support for Indian FX reserves and the rupee.

Other things being equal, the additional new source of demand should put downward pressure on Indian government bond yields. In turn, this would tend to reduce the government’s cost of capital, thereby helping investment activity, including in key development areas such as infrastructure and education.

Perhaps most importantly of all though, we think India could benefit greatly from sending a strong signal of being more open to foreign capital and diversifying its bondholder base. Relatedly, there is an argument that increased foreign sovereign bond ownership (compared to the presently more captive largely domestic-only ownership), could help to improve fiscal discipline.

How investors stand to benefit

When it comes to the investor perspective, the benefits of Indian bond inclusion in global indices are especially compelling in our view. At the most basic level, improved access to a large and liquid $ 1.1trn local government bond market, that is third only in Asia to Japan and China in size, clearly amounts to a very significant expansion of the investment opportunity set.

However, it is some of the more specific characteristics of the Indian market that would be of greatest interest for global bond investors. In particular, we think three positive features really stand out.

Firstly, Indian governments bonds have low correlations to other regional and global bond markets, which is something that really heightens the potential diversification benefits of ownership. A well-known reason for this is India’s relatively low level of global economic integration, with around 75% of its growth being domestically-generated.

Another quite significant factor we think is the historically very low level of foreign ownership, which has helped to make Indian bonds seem quite immune from big shifts in global investor sentiment. It should be noted that this has long been one of the most oft-cited counter-arguments within India for allowing greater foreign investor access to its bond markets. However, policymakers will judge (rightly in our view) that limited opening now would outweigh any such potential disadvantages.

Another key benefit for investors of Indian bond index inclusion is improved opportunity to get exposure to a very large, fast-growing economy with improving fundamentals. In this respect, there are numerous positive trends that can be referenced.

For instance, factors such an improving growth profile (helped by an 8-year track record of reforms), strengthened balance of payments, enhanced central bank credibility and significantly reduced currency volatility. Indeed in some respects, despite being Investment Grade, we think it’s possible to argue that India government bonds are rather underrated at present. By way of example, India has a lower sovereign credit rating than Italy despite having a debt-to-GDP ratio that is around 70 percentage points lower.

Finally, and perhaps most compelling of all for global bond investors, given the continuing extended environment of very low global yields, is the attraction ofhigh Indian bond yields. Indeed, as shown below, the Indian 10-year local government bond yield of over 6% compares favourably to many other similarly-rated larger emerging markets.

Furthermore, the rate of yield pick-up compared to 10-year treasury yields of around 1.5%, and still negative bund yields, would certainly be a powerful draw for many global income-seeking investors.

 10-year yield (%) comparison of selected emerging market government local currency bonds

Source: Bloomberg as of end-November 2021. * JP Morgan GBI-EM Global Diversified  Index

 Summary

Putting everything together, the likely imminent inclusion of Indian government bonds in leading global local currency government bond indices should offer significant benefits for both the issuer and investors.

For the latter in particular, we think index inclusion presages significantly improved market access to the bond market of a very large and fast-growing economy with structurally improving fundamentals. At the same time, this is also combined with compellingly attractive yields and historically low correlations with other parts of the global bond complex.