Fixed Income: India Defending and US Inflation Surprise

Our proprietary Net Foreign Asset model views India as a 3-star country, having net foreign liabilities less than 50% of GDP and is therefore within our parameters to invest. We have not looked to add a position in India simply because we cannot find value within the country, moreover the sovereign has no outstanding USD issues. 

According to reports earlier this week, India asked the Reserve Bank of India (RBI) to either buy back government bonds or conduct open market operations (OMO) to bring yields down from the uncomfortable levels last experienced in 2019. Having spiked as high as 7.49% on Monday, the bonds rallied on OMO speculation, but are currently trading only marginally lower, at 7.21%. The fall in yields has also been supported by the recent rally in US Treasury yields and a move lower in oil prices. 

Defending the yield curve would naturally see a weaker rupee, and we heard that the RBI also moved to defend the currency from speculative traders, by prudently deploying its vast FX reserves, which have fallen below USD600bn, on the spot, forwards and NFD markets. The rupee responded, falling from its dizzy record highs of 77.53 against the dollar, but hit a new high this morning, and is only marginally lower currently, trading at 77.47, amid CPI data due later today.

The RBI surprised markets last week when it raised its key interest rate by 40bps to 4.4%, the central bank’s first hike in almost four years. More rate hikes are expected as India’s CPI is expected to have jumped to 7.42%yoy in April, its highest level in 18 months and well above the central bank’s tolerance of 2-6%; stagflation concerns have increased. The bank will likely raise its inflation forecasts at the meeting next month and maintain intervention to cool both the volatility in the currency and bond yields if the issues persist.

Our proprietary Net Foreign Asset model views India as a 3-star country, having net foreign liabilities less than 50% of GDP and is therefore within our parameters to invest. We have not looked to add a position in India simply because we cannot find value within the country, moreover the sovereign has no outstanding USD issues. 

The nation’s most valuable company, Reliance Industries has a number of USD outstanding issues, and makes up the longer-end of the nation’s USD corporate curve. Reliance actually has a higher rating than the government, at Baa2/BBB+, versus India’s Baa3/BBB- rating. If we look at an example, Reliance 3.625% 2052s is currently trading at a spread of 205bps, with similarly rated bonds with a duration of 16 years trading at ~185bps. We calculate the bond therefore has an expected return and yield of 8.55% and less than one notch of credit cushion. Many investors would look at the bond's attractive yield of 5.19%, however, we favour higher rated sovereign and quasi-sovereign bonds with attractive risk-adjusted returns, for example Abu Dhabi Government 4.125% 2047. Rated Aa2/AA the bond had an expected return and yield of 13.3% and a three-notch uplift. 

In other news, with many market makers assuming US inflation peaked in March, the US reported CPI above expectations at 8.3%, vs the market consensus at 8.1%. Biden reacted, calling price rises “unacceptably high”. He stated that “while I will never interfere with the Fed’s independence, I believe we have built a strong economy and a strong labor market”. Agreeing with Fed Chair Powell’s statement that inflation is the “number one threat” to the US economy, he added, “I am confident the Fed will do its job with that in mind”. Amid the war in Ukraine, Covid lockdowns in China, thus strained supply chains, it looks like inflation is far stickier than most expected. In response to the inflation print, Former New York Fed President, Dudley says he thinks the Fed should hike to 4-5% or higher at the expense of economic growth and unemployment. However, other Fed members opined that the Fed will likely stick to 50bp rate hikes, and there is not a case for larger moves currently.

Freddie Coldham
Fund Manager, Fixed Income