Inclusion of Indian bonds in JP Morgan GBI-EM Index

Will this change lead to an increase in the liquidity of Indian Government Bonds?

No

GBI-EM Index follows a ‘buy-and-hold’ type of strategy. GBI-EM index does not have a particular duration target. So, bonds once purchased remain on the balance sheet of the asset manager for a very long time, or until 13 months are left before maturity. 

The best analogy we can find is when the Federal Reserve Bank of United States purchased bonds of specific maturity during the ‘Operation Twist‘ of Quantitative Easing. In this operation, Fed’ purchase of certain long dated bonds did not increase the liquidity of those bonds. Fed actually informed the market which bonds it will buy, and when, which lead to a momentary uptick in the price of those bonds (as expected). 

 We expect that the liquidity of Indian bonds purchase (or purchased) will actually decrease since the funds are going to be following the buy-and-hold strategy of GBI-EM Index.

Should we expect a significant uptick in price of Indian Bonds eligible for inclusion within the GBI-EM index?

No

Limiting our attention to ISINs listed under Fully Accessible Route, we see USD 420 Billion of outstanding Indian Sovereign debt, out of which approximately USD 330 Billion have a remaining duration of 5 years or more. Assuming a monthly purchase of USD 2.5 Billion out of this USD 330 Billion (and growing) pool of debt, the uptick would be transient, if at all. We expect USD asset managers to partner with local fund managers and primary dealers in India to acquire these bonds in size. And, as a result, we expect that there will be negligible frictions available to exploit.

FPIs are permitted to invest in all dated Government Securities with more than 3 years to maturity (but still limited to USD 25 Billion per FPI, which is a really high limit!).

Will this change bring in huge amounts of USD inflows and hence cause the Indian Rupee to appreciate against the US Dollar? 

No. 

The expected USD inflows due to this index alone are going to be in the range of USD $2-3 Billion a month. Compare that to the change in FPI Net Investments from +$36B in 2020-21 to  -$16 B in 2021-22. Such a wide range makes a net inflow of $23 B difficult to interpret, especially given FPIs are a minor driver of net FX flows in comparison to trade  (import/export). An important fact to understand is that GBI-EM is a local currency index, which means foreign asset managers hold EM bonds in their native currencies and do not hedge their FX exposure. So, this means that this index will make dollars flow into India, but the scale is not large enough to have any material effects on FX rates.

Interest rates in the emerging markets have been much higher than in the US. So, this index must be a good investment, providing high yields (high returns) to US investors. 

No.

Although it is true that sovereign bond yields are much higher in the developing world (Brazil 11.5%, South Africa 10.5%, Mexico 10%, Turkey 25%, etc.), US Dollar’s relentless rise against these currencies makes the total returns look poor when they are converted back into USD. The 10 year return on GBI-EM Index for a typical US-based investor is -1.5%, and 5 year return is -0.5%. After adding an expense ratio of -0.3% per year, the total long-term return on this index looks very bad to a US-based investor.

Are there other indices like GBI-EM, which may include Indian Government Bonds soon?

No.

Wisdom Tree’s Emerging Market Local Debt Fund (ELD ETF) is another fund that holds Emerging Market debt in respective local currencies. Surprisingly it even holds the debt of Russia (12% yield), Peru (7.5% yield) and Turkey (25% yield), all of which tend to have enormous FX volatility. But this fund does not hold Indian Sovereign debt. SPDR’s EBND ETF, which tracks the Bloomberg  EM Local Currency Government Diversified Index is another such local currency debt fund. EBND holds the sovereign debt of Romania, Peru, Chile, Turkey, and even Colombia, but not India. Hence, we think that ELD and EBND will not include Indian Sovereign Debt in the future. Even if they do, the AUM of these funds (and other funds related to their indices) is quite low making them insignificant.

Surely, the inclusion of Indian Government Bonds in a large and reputed index like JPM’s GBI-EM Index will increase the creditworthiness of Indian Government Bonds in the global debt market. 

No.

Despite inclusion in major Local Currency Debt indices, many emerging countries have seen their yields going up and currencies going down (relative to USD) in the last 5 years. Both trends indicate worsening creditworthiness. The creditworthiness of a country is determined by its ability to collect taxes, in addition to other domestic market factors such as inflation, economic growth, and stability in political, regulatory and business environments. It is important to understand that the investor of Local Currency Debt is taking exposure to both local interest rates and FX risk. A US-based investor will suffer a loss when the EM debt yields rise or when the EM currency depreciates against the dollar. And, evidently, a US-based investor has suffered huge losses on both fronts (local interest rate risk and fx risk) in the last 10 years on the debt of many emerging market countries.

I understand it now. Investing into Indian local currency bonds must have been a loss-making investment for US-based investors, and so they do not like to include Indian bonds in their indices. 

No. 

An investment made into INR Government Bonds 10 years ago would have yielded an annualized return of 5% in USD terms. Likewise, an investment made into Indian Government Bonds 5 years ago would have produced an annualized return of 4.8%. So, historically, local currency investments into Indian Government Bonds have largely remained quite profitable for a US-based investor, after including for both interest rate risk and fx risk. 

So, is it true, then, that these other indices (besides JPM’s GBI-EM) continue to include sovereign debts from many emerging countries despite persistent losses and worse future outlook, but continue to exclude and ignore Indian sovereign debt despite positive historical returns and positive future outlook? 

Yes. 

That seems to be the unfortunate reality. Despite capital controls, foreign institutional investors (FIIs) have enjoyed very liberal caps on investment in rupee-denominated sovereign debt (USD 25 Billion) since 2013. In October 2019, FIIs (renamed as Foreign Portfolio Investors) were given explicit approval to invest in various kinds of government and commercial debt in India via the Foreign Exchange Management (Debt Instruments) Regulations (Notification).

Foreign ownership of Indian Sovereign debt still remains under 2% of all outstanding debt. Compare that to the foreign ownership of sovereign debt of Indonesia (~ 25%) or that of South Africa (~ 35%).