Indian Bonds Loosing Sheen

Why in news?

Foreign investors have sold a net $1.12 billion in Indian debt market (primarily bonds) this month, the highest since December 2016.

What are bonds?

A bond is a debt investment.
Corporates or governments issue bonds directly to investors, instead of obtaining loans from a bank.
This is to raise money and finance a variety of projects and activities.
The investor buys the bonds and loans money to the entity and in turn receives fixed interest.
This is for a defined period of time (till maturity date) and a variable or fixed interest rate (coupon rate).

How are bond prices, bond yields and interest rates related?

Price - Face value is the money amount the bond will be worth at its maturity.
It is also the reference amount the bond issuer uses when calculating interest payments.
The issuance price of a bond is typically set at par, usually $100 or $1,000 face value per individual bond.
But a bond's price changes on a daily basis, just like that of any other publicly-traded security.
The actual market price of a bond depends on various factors including:

Interest rates - The price of a bond primarily changes in response to changes in interest rates in the economy.
For instance, say the investors get a better return in corporate bond either due to rise in their rate or due to fall in rate of government's bond.
This would make the corporate bond much more attractive.
Investors in the market will bid up the price of the bond until it trades at a premium that equalizes the prevailing interest rate environment.
Yield - In simple terms, yield is the amount of return that an investor will realize on a bond.
If the investor holds the bond to maturity, s/he will be guaranteed to get the principal amount back plus the interest.
However, a bond does not necessarily have to be held to maturity by the investors.
Instead, investors may sell them for a higher or lower price to other investors.
The bond prices and yields generally move in opposite directions.
This is because, as a bond's price increases, its yield to maturity falls.
E.g. for a bond purchased with a par (face) value of $100, and a 10 percent annual coupon rate, its yield would be 10% (10/100 = 0.10)
If the bond price fall to $90, the yield would become 11% (10/90 = 0.11).

What is happening to Indian bonds?

Indian bonds were once regarded as hot emerging market play.
The country received about $26 billion in inflows last year through this.
Notably, higher bond yields and stable currency have been driving factors for its attractiveness.
But Indian bonds are now losing their allure with foreign investors.
The 10-year bond yield dropped to as much around 7.3% from 7.62%, its lowest since January end.

What are the driving factors?

Rupee - Rupee weakness is one of the major reason for the change in investor sentiment.
The partially convertible currency has lost nearly 2% against the US dollar this year.
A fall in local currency ultimately erodes returns for foreign investors.
US Fed Rate - The interest rates hikes in the US could lead to outflow of foreign portfolio investor funds from emerging markets.
This is a concern for India, as funds would move out of the country to be parked in US Treasury bonds.
Economic concerns - Inflation has stayed above the RBI's 4% target for 5 consecutive months.
Adding to this is the fear of the central bank raising the interest rates further.
Moreover, rising energy prices are widening India's trade and current account deficits.
The government has also loosened its fiscal deficit targets to finance increased spending ahead of general elections due by 2019.
Banks - The public sector banks, typically the biggest lenders to the government, have turned wary of lending.
State-run banks are unable to buy government bonds amid widening treasury losses.
This inability also reduced confidence in the country's debt.
State-run lenders are estimated to be been selling Rs 5.30 billion of government debt on average every day this year.

What is the way forward?

Domestic investors are already concerned with widening fiscal deficit.
Banks hold about 30% of the government bonds while foreigners own about 7.5%.
Thus foreign selling is also now adding pressure on the market.
A new investor class is needed to absorb upcoming bond supply.
It is thus essential that the RBI re-examine the rule limiting the role of foreign investors in the bond market.

Source: The Hindu, Economic Times