Inclusion of Indian Bond in JPM EM Global Bond Index Spells ‘License To Grow’

“Bond, James Bond” has to be without a doubt the most iconic and popular dialogue in the history of world cinema. Nonetheless, in the world of finance, it’s not about Agent 007 with the ‘license to kill’ but rather the financial instrument, the bond. Vaishnavi Chauhan explains how the recent news about bonds will impact the turns of the future market scenario 

Recently, Indian government bonds have been included in the JP Morgan Government Bond Index – Emerging Market (GBI-EM) starting June 28, 2024. This process will unfold over 10 months, and conclude on March 31, 2025. Initially, India will have a 1 per cent weight in the JP Morgan EM Bond Index, which will gradually increase to 10 per cent over this period. This inclusion is anticipated to bring USD 20-22 billion in inflows into the Indian bond market. 

Not All Bonds Are Equal
When we talk about bonds, there are various types. Which ones are included in the JPMorgan Emerging Market indices? Only Indian government bonds issued by the Reserve Bank of India (RBI) under the fully accessible route (FAR) will be included. All FAR-designated Indian government bonds (IGBs) maturing after December 31, 2026, will be included. Investing in government securities has become much easier for non-resident Indians (NRIs) through the RBI retail direct platform. This platform offers several benefits, such as no brokerage fees, commissions, annual maintenance fees or account opening charges. 

The RBI introduced the fully accessible route on April 1, 2020, allowing non-residents to invest in specified government bonds without restrictions. This initiative, announced in the budget, opens certain categories of government bonds fully to nonresident investors, eliminating investment ceilings for eligible participants. FAR operates alongside existing investment routes, such as the Medium Term Framework (MTF) and the Voluntary Retention Route (VRR). 

The primary benefits of FAR include making it significantly easier for non-residents to access Indian government securities markets, facilitating the inclusion of these securities in global bond indices, and attracting stable foreign investment in government bonds. NRIs can invest in government securities on both repatriable and non-repatriable bases, depending on the terms of the investment scheme, without any inherent restrictions. 

U.S. Inflation versus India
Bonds are known for their stability and fixed returns, but they are still affected by inflation. When inflation rises, central banks usually increase interest rates to manage it. This leads to new bonds being issued with higher interest rates, causing the prices of the existing bonds to drop to match the higher yields of the new bonds. On the other hand, when inflation decreases, central banks cut interest rates, resulting in new bonds with lower interest rates. This boosts the prices of the existing bonds because they offer relatively higher returns. 

The inverse relationship between interest rates and bond prices is crucial to understand. Inflation rates influence interest rates, which in turn affect bond yields and prices. Different types of bonds react differently to inflation. Generally, government securities (G-Secs) and AAA-rated bonds respond more slowly to inflation compared to lower-rated bonds, which tend to be more volatile. During the expansion phase, the economy experiences strong growth, characterised by low interest rates, and rising employment and wages. 

However, the peak marks the end of this growth, with increasing prices and inflation. To control inflation, the Federal Reserve raises interest rates in the U.S., initiating a contraction phase. In the contraction phase, prices fall, growth slows and employment drops. Prolonged contraction can lead to recession and deflation. As the economy reaches the trough, prices hit their lowest point before the cycle restarts, with rising inflation. In July 2023, the inflation rate in the United States was 3.18 per cent. This increased to 3.67 per cent in August, and by September 2023, it was 3.70 per cent. 

By January 2024, the inflation rate had fallen to 3.1 per cent. It then rose to 3.2 per cent in February and 3.5 per cent in March, reaching the year’s highest mark. However, in April, it decreased to 3.4 per cent. As of May 2024, the current inflation rate in the U.S. stands at 3.3 per cent. In India, retail inflation eased to 4.75 per cent in May 2024, the lowest in 12 months since May 2023. According to the latest forecast, the Reserve Bank of India has kept its inflation projection steady at 4.5 per cent for the fiscal year 2024–2025. 

Governor Shaktikanta Das mentioned that inflation is expected to be 4.9 per cent in Q1, 3.8 per cent in Q2, 4.6 per cent in Q3 and 4.5 per cent in Q4, with risks evenly balanced. With anticipated declining inflation, experts predict there could be a rise in foreign institutional investor (FII) inflows in the near future. This outlook suggests positive expectations for the economy, aiming to attract more foreign investments into the country. Hence, higher inflows and expected lower rates will help the equity market in a big way as bond yields go down. 

Equity Bonding with Bond
Understanding earnings yield and bond yields is crucial for analysts and asset allocators. These yields help determine whether to allocate resources to equity or debt, although they are just one of the factors to consider. Let’s take a closer look at how bond yields and the equity market interact and how bond yields impact equity markets. Generally, equity valuations and bond yields move in an inverse relationship, with some exceptions. The bond yield and the equity market relationship operate in two key ways:
1. Impact on Cost of Capital - When bond yields rise, the weighted average cost of capital (WACC) increases. This means future cash flows will be discounted at a higher rate, negatively affecting equity valuations.
2. Cost of Funds and Solvency Risk - Higher bond yields lead to higher costs of funds for companies, increasing their solvency risk. This also negatively impacts equity valuations. 

In summary, understanding the relationship between bond yields and equity markets is essential for making informed investment decisions. 

Understanding Inflation’s Impact on Discounted Cash Flow (DCF) Analysis
Discounted cash flow (DCF) analysis is a method used to value a business or project by forecasting future cash flows and discounting them to their present value. However, inflation can influence the accuracy of DCF analysis by reducing the purchasing power of money over time. High inflation can have a significant impact on the present value of future cash flows, potentially lowering business valuations. Conversely, lower inflation rates tend to increase the present value of future cash flows and can lead to higher business valuations. 

This relationship is particularly important for investors considering growth companies. These companies are often expected to generate positive cash flows in the later years of their business cycle. Investing in bonds issued by such growth companies as compared to value companies over the long term can be a profitable strategy. By purchasing these bonds, investors can benefit from regular interest payments and the eventual return of their principal investment, which is especially attractive if the company’s growth prospects materialise as expected. This approach allows investors to participate in the potential success and profitability of growth companies while mitigating some of the risks associated with equity investments. 

Conclusion
In the coming times, the bond market in India is poised for growth, marking a significant stage. Bonds not only provide stability to portfolios but also offer lower risk compared to equities. The latest development of the Indian government bonds being included in the JP Morgan Government Bond Index – Emerging Market (GBI-EM) is set to open new opportunities. This inclusion is expected to attract more FIIs to India, boosting investments and benefiting growth-oriented companies. Overall, this news bodes well for the Indian markets, promising positive impacts and signalling a potential rise in bond market activity.