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Informist, Friday, Oct. 25, 2024

 

By Aaryan Khanna

 

NEW DELHI – Foreign portfolio investors are unwinding a trade that was their preferred way of accessing India's government bond market in 2024, reducing risk ahead of the US presidential election on Nov. 5. Total return swaps have been in vogue ever since the announcement of India's inclusion in global bond indices as the derivative offers offshore traders an opportunity to gain exposure to domestic bonds without getting through cumbersome regulations for onshore registrations.

 

"Some TRS (total return swaps) are being unwound ahead of the US election," a dealer at a foreign bank said. "Offshore traders also need an opportunity to lighten their position before the risk event. Domestic traders have also been readjusting."

 

In a total return swap, an entity gains exposure to an asset by entering into a contract with another party, which owns the asset. In this case, a foreign bank operating in India buys Indian bonds and passes on the total return to a client in exchange for a fee. India's bonds have outperformed those of other emerging markets this year amid a confluence of positive factors – their inclusion on global bond indices, lower supply amid the government's fiscal consolidation, and hope of interest rate cuts beginning in 2024-25 (Apr-Mar).

 

The unwinding of these trades was gradual at first, but has accelerated over the past week as odds of Republican candidate Donald Trump's victory in the US election, considered an unfavourable outcome for risk assets, have risen, dealers said. Trump's policies are expected to drive up the 10-year US Treasury yield if he wins the election, leading to a "Trump-premium" in US Treasuries. Increasing odds of a victory for Trump have led the 10-year US Treasury note to break a 200-day moving average earlier this week; it rose to a three-month high early on Thursday.

 

This has hoovered up foreign funds away from emerging markets, including India. After peaking at over INR 2.5 trillion in early October, foreigners' holdings of bonds under the fully accessible route have fallen by INR 67.83 billion, or around $800 million, according to data from Clearing Corp. of India.

 

A conspicuous sign of total return swaps being unwound over the past week was the quantum of gilt sales by foreign banks, dealers said. Between Oct. 16 and Thursday, foreign banks sold INR 193.40 billion of gilts in the secondary market, by far the top net sellers over the period, Clearing Corp. data showed.

 

Bonds under the fully accessible route have no investment limits for foreigners and are being included in global bond indices over the next 17 months. The outflows are only a speed bump after nearly $19 billion of inflows into fully accessible route bonds since the announcement of the J.P. Morgan index inclusion last September, over $14 billion of which has come in 2024 alone. Since the sales by foreign banks intensified from Oct. 16, the yield on India's 10-year 7.10%, 2034 gilt has risen by only 5 basis points to 6.82% on Thursday. 

 

However, the US election could only be the beginning of a lean period for foreign interest in India's bonds, which might persist till the end of 2024, dealers said. For one, high inflation in Sept-Oct is seen pushing back India's policy rate cuts beyond December, even as the US has begun cutting rates. In addition, heightened geopolitical tensions in West Asia have led to volatility in crude oil prices, a key concern for India, which imports 80% of its oil needs.

 

"(FPI) clients are looking to run down India exposure (in fixed income) back to equal-weight by the end of the year," a dealer at a primary dealership said, referring to meetings conducted in mid-October. "They were running a couple of months ahead of the pace of inclusion, but now the year-end is coming and so the pace of flows will definitely slow." India's bonds are being added to J.P. Morgan's emerging market bond index over the course of 10 months starting Jun. 28, with a 1% increase in weightage every month.

 

Despite the seasonal lull and the volatility related to the US election, India remains one of the most attractive emerging markets for fixed income investors due to its strong macroeconomic buffers and stable currency, dealers said. A breather now could lead to greater inflows in the new year, as interest rate differentials with the US are set to widen.  End

 

US$1 = INR 84.07

 

Edited by Avishek Dutta

 

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