Are Indian bonds too expensive and Chinese bonds a bargain?

Prospects of offshore Indian sovereign bonds announced. Chinese govvies are one of the laggards this year.
Radhika Rao, Eugene Leow16 Jul 2019
    Photo credit: AFP Photo

    India: INR bonds extend post-budget rally; too expensive now?

    With the recent Budget batting in favour of fiscal consolidation, India’s 10Y (generic) bond yields have corrected sharply – from 6.75% ahead of the budget to 6.45% yesterday. Correction in the rate sensitive 2Y yields was relatively smaller, from 6.23% to 6.17%, having already baked in monetary easing expectations. This has led to flattening in the yield curve vs a month ago, with 6.4% offering support for the 10Y, while 2Y yields stay above 6%. A strong dovish signal will be the next trigger for a break below.

    Global drivers are supportive, as US yields harbour expectations of a dovish US Fed and a likely rate cut at the meeting later this month.

    Domestic catalysts for bonds are largely positive in the short-term, barring yesterday’s downbeat trade numbers. June exports declined -9.7% YoY accompanied by a similar decline in imports, keeping the trade deficit wide at above USD15bn. Separately, June retail and wholesale inflation remained below target, whilst core CPI inflation continues to retreat mirroring subdued demand pull pressures. Oil prices continue to seesaw on geopolitical rumblings, with a break above USD70pb needed to shake confidence in the currency and yields. These cement our expectations of a follow-up 25bp cut in August, a fourth this year. Beyond August, we are holding out for another rate cut, likely in 4Q19. If inflation continues to stay below 4%, helped also by a favourable spatial spread and narrower shortfall in the rainfall, more easing is in the pipeline. Two announcements are due this month – RBI capital framework panel will shed light on a quantum of RBI dividends (key for revenues), followed by the liquidity framework report (as announced in the July policy review).

    Prospect of a sovereign bond issue announced in July’s Budget has divided market participants,with few ex-RBI Governors speaking against such an issuance. While the government’s intention is to tap a new investor base and lighten domestic issuance, concerns arise - a) exchange rate risk borne by the government); b) small net savings on cost on hedged basis; c) another avenue for external volatility to permeate through to the domestic markets; d) risks of cannibalising portfolio debt inflows; e) increase in external debt (foreign reserves are 70% of total external debt).

    These are pertinent risks, which might require the authorities to take the ‘good with the bad’ if issuance plans stay on track. Given the skewed nature of debt to equity FPI flows into India (INR7 equity for every INR1 debt), door can be opened to more dollar debt. Better FX reserves stock is another positive, provided total quantum of issuance is kept at manageable levels. Speculation for a USD10bn issuance has surfaced, likely in 2H FY20 (Oct-Mar); the final quantum is likely to be smaller in our view, given the time remaining and a maiden foray into sovereign offshore debt.

    Rates: China govvie underperformance presents an opportunity

    Chinese govvies are one of the laggards this year as the curve bear flattened. Moreover, due to the yield bounce in April (that came on the back of a risk rally amid hopes of an economic recovery and trade deal), the 20bps rally in 10Y yields (since May) got masked. The underperformance in shorter tenor bonds (versus US Treasuries) is more marked, with 2Y and 5Y yields higher than they were at the start of the year. This development seems a bit odd given that high frequency data have pointed to slowing Chinese growth for multiple months. Weak growth was eventually confirmed by the 6.2% YoY GDP print released yesterday. While retail sales and industrial production numbers surprised on the upside, it is probably insufficient for market participants to conclude that the worst is over.

    The authorities’ reluctance to embark on more aggressive easing is probably the key reason why China govvies did not join the global bond rally.The People’s Bank of China (PBoC) has kept the weighted average open market operations (OMO) rate in a tight range (3.15-3.30%). Meanwhile, the 7D repo did drift modestly lower over the past couple of months. Expectations of monetary loosening were probably overblown at the start of the year. With property prices rising again, room for easing may be more limited than initially thought. However, this should not deter foreign investors. 10Y China govvies have a 110bps yield advantage over their US counterparts. This is wide by recent standards. Against a backdrop of swelling negative-yielding bonds, foreign interest should pick up.

    Radhika Rao

    Economist – India, Thailand & Eurozone

    Eugene Leow

    Rates Strategist - G3 & Asia

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