Demand surges for India debt market access products

Real money accounts have driven a 30% rise in sales across the sector.

india

Increased appetite for India fixed income from real money accounts, combined with the difficulty such investors face in gaining a licence to trade onshore directly, has driven a 30% rise in market access product sales over the past 12 months, according to dealers.

The Indian authorities took steps to make access to the country’s financial markets easier in June 2014 when it replaced the two-decade-old Foreign Institutional Investor scheme with the Foreign Portfolio Investor (FPI) structure. However, direct access via this channel is still mostly restricted to global banks and top-tier asset managers. This leaves just real money managers – institutional investors that don’t use leverage, such as insurers and pension funds – and private banks needing dealers’ help to access the market.

”We have had a huge pick-up in volumes through our FPI channel,” says Singapore-based Raghavan Rajagopalan, global head of financial markets structuring for Standard Chartered. ”All the large real money accounts, sovereign wealth funds, even smaller asset managers, are jumping on the bandwagon. We saw about a 25-30% increase in volumes in the second half of 2014, compared to the same period the year before, and this trend has continued.”

This rising interest in India saw the $25 billion quota for foreign holding of government debt reached by August, with investors then shifting their attention to quasi-sovereign and even corporate debt.

According to Yeong Chuan Teh, Singapore-based head of rates trading at Standard Chartered, last year’s FPI reform was a critical aspect of the recent expansion of the India fixed income access product market.

“There were two ways of getting into India in the past – the FII route, which was very cumbersome or you could access it synthetically via an offshore derivative instrument (ODI). With last year’s reform, offshore investors have migrated away from the ODI route and are investing directly via the FPI channel.”

Teh says volumes on the ODI side have remained constant, however, due to interest from both corporates and asset managers that are in the process of applying for the full FPI licence.

Demand for India access products is driven by high yields relative to other emerging Asia economies, with the exception of Indonesia. Even with the Reserve Bank of India’s (RBI) surprise 25 basis point rate cut last week the policy rate stands at 7.5%.

Each country has slightly different interest rate benchmarks, which make exact comparison difficult with other emerging Asia economies, but all are significantly lower than India’s. Malaysia’s overnight policy rate stands at 3.5%, Thailand's one-day repo rate is 1.75%, while the Philippines’ overnight repo rate is 4%, according to data provider Trading Economics.

The result, say dealers, is a yield of 7-8.5% if the foreign exchange risk is left unhedged, depending on whether the underlying instrument is government-, quasi-government- or bank-issued.

Indonesia’s interest rate is also 7.5%, but foreign activity already accounts for more than 40% of onshore bond holdings, versus less than 5% in India, according to Aberdeen Asset Management, meaning there is much more scope for growth in the latter market.

While India’s interest rates are high in comparison to other regional economies, they have been at this level or higher since late 2011. But the current spurt of interest has been prompted by structural reforms by the new Narendra Modi government and then turbo-charged by the recent rapid fall in the oil price. A year ago it stood around $110 a barrel and, despite a recent rally, is still only around $60. This has contributed to a major improvement in India’s balance of payment, given that the country is the world’s fourth largest oil importer, according to the US Energy Information Administration.

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“The recent India story started with the election of Modi and has been given a real boost by the falling oil price,” says William Shek, Hong Kong-based Asia Pacific head of rates at HSBC. “The falling price is a real boost to the country’s fiscal position.”

Falling oil prices and structural reforms have seen rupee volatility drop sharply since the August 2013 taper tantrum, when it hit a low of 69 to the dollar in August 2013: current one-year rupee/dollar implied volatility is around 8.5%, according to RBC Capital Markets. Despite this, Shek says that some investors are concerned about potential forex risk.

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“There are very few questions about the credit spread, and most people agree there will be a long-term Indian government bond rally but there is a lot of debate about forex risk. Should they hedge or not? I've seen people hedge one third of their exposure – so if they buy $100 million of bonds, they hedge out a third of this on the NDF [non-deliverable forward] market.”

The decision to hedge appears to depend on the type of investor. Adam McCabe, head of Asian fixed income at Aberdeen Asset Management in Singapore, says the RBI has gained sufficient control over exchange rates for the fund house to invest on a non-hedged basis. Aberdeen invests directly via its own FPI channel and not through bank access products.

“It comes down to central bank credibility, a combination of the moves put in place in September 2013 and the amount of forex reserves the RBI has built up since,” says McCabe. “The inflow of international funds into both the equity and fixed income markets are all positive for reducing currency volatility. And that makes an unhedged exposure quite appealing.”

This view was backed by the Taipei-based head of fixed income for a Taiwanese life insurer that recently started investing in Indian corporate paper via the FPI channel. While he acknowledges the risks, he says the overall macro and fiscal picture means the cost of hedging exceeds the perceived level of risk.

“Investing in India means you face forex risk, but we expect the political and economic reforms will drive the growth of its economy,” he says. “Even if the [US] Fed starts to raise interest rates later this year, the rupee will be still relatively safer than other emerging market currencies. If you do a 100% hedge on rupee, it will eat up to 5% of your yield, but as we are still bullish about the rupee, the forex risk is not a very big concern at the moment.”

Not all Taiwanese firms are convinced. Winnie Huang, chief risk officer at China Life Insurance in Taiwan (no relationship to the mainland Chinese firm of the same name), says her firm doesn’t invest in India due to rupee volatility. “It will potentially wipe out all of the gains made from the bond investment,” she adds.

Ryan Chan director of cross-asset solutions at Societe Generale in Hong Kong, says that retail investors share Huang’s view. The French bank has seen significant activity from private banks, particularly those based in Singapore, which tend to have a more nuanced understanding of the Indian market than their Hong Kong counterparts – and they generally want to ditch the forex risk component.

“Whether the forex risk is hedged depends on the end client,” says Chan. “For retail, most of them would likely to hedge out their forex volatility – they only want the credit exposure.”

He adds that hedge funds have also been trading Indian rates, but instead generally choose to do so in the offshore Overnight Index Swap market, because these instruments offer a potential for leverage that isn’t available in the onshore market.

Aberdeen’s McCabe says that India is experiencing structural change and therefore the potential for further gains is huge – as a result investor interest is set to continue.

“On a risk-adjusted basis, India is without a doubt attractive – even if you look at the very short-term factor: real yields are high, and that gives the potential for further rate cuts,” he notes. “If the structural changes Indian authorities are implementing come through, you will see a massive gain from country risk and the inflation risk premium will fall. Many other markets have enjoyed this rerating – it happened in Korea a decade ago and potentially it could happen in India.”

In addition to providing high returns for investors, the inverse relationship between bond yields and prices means there are potential significant capital gains for investors if the RBI decided to cut rates further.

Sue Trinh, senior currency strategist at RBC Capital Markets in Hong Kong, says this is a real possibility. “Given the RBI’s stated target for real interest rates of 1.5-2.5% – currently it sits at 2.39% – we expect a further 50 bps of rate cuts this year.”

There appears to be a consensus on the positive outlook for India, but SocGen’s Chan says it’s not yet clear where the next opportunity in emerging Asia fixed income will come from.

“At this point the yield in other onshore emerging markets in Asia, taking into account the onshore/offshore basis, is too low to make them attractive re access products but this is all cyclical – we never know when it will come back.

"Each country has its own idiosyncratic credit and macro-economic environment. Look at China – the onshore/offshore basis has moved a lot since last year, and access products [for that market] don't really make a lot of sense anymore, particularly on the fixed income side.”

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