Inflation-linked bonds will help India persuade more long-term foreign institutional investors to buy into its funding to its debt market, as strategists say such an asset class will prevent rising prices from eroding bond returns and offer investors higher yields for the relatively stable bonds.
The country’s inflation rose to 7.81% in September, the highest among nations in the Asia Pacific as well among the Bric group of emerging nations comprising Brazil, China and Russia. Rising inflation depreciates the value of a bond investor’s future interest payments, which is why such a fluctuation in the economic indicator is a natural concern for investors.
“India has one of the highest inflation [rates] in the region so it would be good to have some instruments with embedded inflation protection in it,” said Pin-Ru Tan, an Asia rates strategist for HSBC in Hong Kong.
Business Today cited Reserve Bank of India deputy governor HR Khan on October 13 as saying that the country will issue these bonds soon, after failing to jumpstart them in 1997 with their INR7 billion (US$130 million) bond that was linked to their wholesale price index. The Reserve Bank of India said in a December 2010 technical paper that inflation-linked bonds will provide investors with a means to diversify their funds amid high inflation and improve the depth of the government bond market.
Most investors of inflation-linked bonds are buy-and-hold investors such as life insurance companies and pension funds. The lack of turnover makes these bonds less volatile and allows them to trade less in tandem with conventional government bonds. This allows investors to take advantage of India’s higher yields as well as a means to diversify risk within their portfolios.
Issuing these bonds also benefits India’s government, as the bonds can be used as a signal to the financial markets that the country is trying to control inflation.
“It’s also not only about the demand, it is also a good instrument to have from the policy angle. If a country is running high inflation, inflation-linked bonds can be issued as a sign that the authorities are really determined to curb inflation because if they don’t, the debt financing costs may rise,” said HSBC’s Tan.
Tan added that if India were to issue inflation-linkers, the instruments will usually be denominated in rupee in the 10-year tenor as was the case of Thailand’s inaugural linkers, which were issued its first inflation-linked bond in a similar format last year.
It would also be sensible to launch its first linker bond through book building rather than an auction, as that will give investors more time than a couple of hours to buy the bonds and also allow the government to guide expectations and monitor price bids, said Tan.
The bonds can be issued once a month or once or twice a quarter, depending on how much the Ministry of Finance is willing to allocate the linkers as a proportion of its total government debt. Unlike conventional bonds, which have fixed coupon payments, inflation-linker coupons will differ depending on the government’s future outlook for inflation. The benchmark 10-year government bond yields 8.13%.
Transparent issue plans
India’s previous linkers failed to take off after a lack of protection against deflation fuelled concern that would eat into the principal, and the government did not continue issuance. If inflation-linked bonds were to succeed this time around, Tan says the government will have to draw a clear road map of its plans for investors so that it can constantly attract demand and eventually increase liquidity on that specific yield curve.
The government will also have to raise the quota on foreign bond purchases, as the restrictions are already limiting institutional investor demand in Indian bonds.
“Even though there might be demand, it’s not as if they can wipe the entire issue out, even if they wanted. So there’s a first restriction even if you want to step in. That’s a big one,” said another strategist.
Foreign institutional investors have an investment limit of US$60 billion a year in Indian bonds, of which US$20 billion are for government bonds.
India’s financial authorities will also have to provide consistency in inflation data, as frequent revisions and the existence of various consumer price indexes may cause confusion in pricing the inflation-linked bonds.
“Right now there are a few inflation numbers that come out with the WPI and the CPI and different kinds of CPI. It’s a bit unclear as to what would be the benchmark index to look at. Apart from that, how consistent is the data and what’s the process of revision? It could have a very deep impact on pricing these bonds and the breakevens themselves will be affected,” said Barclays economist Rahul Bajoria.
India’s bonds are the highest-yielding debt in Asia, compared to Indonesia’s 10-year government bond yield of 5.7% and the Philippines’10-year yield of 4.7%. Despite India’s unstable inflation outlook, the relatively higher returns provided by Indian government bonds are hard for institutional investors hard to resist.
“Nominal yields are high enough to offset the kind of inflation risk one can envisage. They will probably take a view and be invested irrespective of the fact that where inflation is,” said Bajoria.
“If you compare it to the credit markets in countries like Argentina and Venezuela, which sort of have a dysfunctional inflation picture as well, but at the same time people are invested in them as well as the yield is just way too high for them not to be invested. The cost of being underweight on any of these countries is very high because it’s quite a big drag on your benchmark performance.”