New Year, Old Problems for India Bonds

Source : HARSH JOSHI:The Wallstreet Journal:JANUARY 3, 2011, 6:54 A.M. ET

After a difficult year, India's domestic bond market seems to have found some stability. But it won't last.

Moving conversely to prices, yields on benchmark 10-year government bonds have fallen-to 7.96% on Monday from 8.18% a month ago. Credit the Reserve Bank of India for this: It paused its interest-rate-raising campaign in December, and has been buying government bonds to ease a liquidity shortage in the banking system.

But this short-term move belies a rough ride for bond investors last year. Before they began to rise in December, the 10-year bonds had fallen sharply over the previous six months as the central bank raised its key policy rates six times in just nine months. Also weighing down the price of existing bonds, New Delhi sold $84 billion in bonds between April and December alone.

This decline has made India a standout among emerging currency bond markets in Asia, which have benefited from rising interest among global investors: HSBC's Asia Local Bond Index rose 12.2% in 2010. The India index rose only 5.2%, but that gain is thanks only to interest payments from the bonds included in the calculation.

In part, this underperformance is because India limits foreign investment in government bonds to a total of $10 billion-a tiny piece of the overall market. For Indonesia, where foreigners hungry for emerging-market debt play a much bigger role, HSBC's index rose 21%.

The decline looks certain to continue. The RBI is facing a persistent inflation problem and rate increases could start again as early as the end of this month, says Robert Prior-Wandesforde at Credit Suisse. One market is already anticipating this: Even as bond yields have come down, the five-year overnight indexed swap rate has risen a quarter of a percentage point.

The government, meanwhile, has shown little interest in letting up on the fund raising. Even after raking in an unexpectedly large $30 billion through the sale of government assets, New Delhi isn't veering from its goal of selling $98 billion of debt by the end of the fiscal year, in March. That would be a record for India, and four times what the government was borrowing as recently as 2007. With the economy still growing fast, there's little reason to think New Delhi will demonstrate much restraint in the coming fiscal year.

Put it all together and the 10-year yield could rise nearly half a percentage point by the end of March, says Manoj Swain, chief executive at bond-trading firm Morgan Stanley India Primary Dealer.

This is one market that isn't likely to benefit from India's broader charm.