India-US bond yield spread at 17-year low

JP Morgan’s decision last week to include Indian government bonds in its Government Bond Index-Emerging Markets (GBI-EM) index and the index suite from June 2024 may be a sort of blessing for India, as the move is estimated to result in an inflow of $25 billion of foreign portfolio investments into the country.

The development comes at a time when the spread between the benchmark 10-year government of India bond and the 10-year US government bond has declined to its lowest level in more than 17 years.

Low yield spreads make Indian bonds less attractive to foreign portfolio investors (FPIs).

The spread was 259 basis points (bps) on Thursday, the lowest since May 2006, when it was 255 bps and down sharply from 345 bps at the end of December 2022 and 357 bps a year ago.

The current spread is also nearly 200 bps lower than the 20-year average spread of 467 bps.

One basis point is one-hundredth of a percentage point.

The narrowing of the yield spread is largely due to a much faster rise in bond yields in the US than in India.

The yield on the 10-year US Treasury bond is up by almost 50 bps in the past one month, as against just 6 bps for the 10-year Indian bonds in this period.

Since the start of the current calendar year, the yield on the US bond is up 76 bps compared to a decline of 11 bps in the Indian bond yield.

In the last two years, the bond yields in the US are up 315 bps compared to a 100-bp rise in India.

A sharper rise in bond yields in the US has been driven by aggressive rate hikes by the US Federal Reserve in its bid to cool down inflation.

Secondly, consumer demand and corporate investments remain strong in the US, which are fuelling demand for bank credit and pushing up rates of new bonds.

In contrast, the Reserve Bank of India (RBI) has announced fewer rate hikes and corporate capex remains weak in India, suppressing demand for long-term credit from the private sector.

Analysts say the sharp decline in the yield spread is making investment in Indian bonds less attractive for FPIs.

“A sharp rise in the bond yields in the US and a resulting compression in spreads is likely to hit capital inflows into emerging markets, including India.

"FPI investment in India’s equity and debt declined sharply in September, and foreign direct investment (FDI) was down in the first quarter of FY24,” said Dhananjay Sinha, chief strategist and head of research at Systematix Institutional Equity.

FPIs have invested $122 million in the Indian debt market this month so far, the lowest in five months and down 89 per cent from their net investment of $923 million in August.

Similarly, FPIs have turned net sellers in the Indian equity market during September after being net buyers for six consecutive months.

The decline in foreign inflows into the country is expected to tighten the liquidity in the Indian financial market, leading to upward pressure on bond yields.

Some of this is already visible.

The yield on the 10-year government of India bond was up around 7 bps on Thursday and the yield rose to a month high of around 7.22 per cent.

If this trend sustains for long, the spread may widen again.

Experts say the yield spread between the Indian and US bonds cannot stay low for long and it’s a matter of time when it rises to long-term average levels.

“Ideally, interest rates in India and thus the yield spread should be much higher given the level of government borrowing and a general capital scarcity in India compared to the US,” said Madan Sabnavis, chief economist at Bank of Baroda.

According to him, the bond yields in India and the US are not linked currently due to a limited participation of foreign investors in the Indian debt market.

Bond yields in India will get slightly more aligned to global rates once Indian bonds become a part of global bond indices.

Currently, the Indian bond market is largely in the hands of government-owned banks and the RBI keeps a tight leash on the volatility in the bond market.