MUMBAI: Foreign investors are unlikely to enter the Indian government debt market, despite attractive valuations, deterred by near-term headwinds, including a depreciating rupee and high hedging costs.
India's 10-year benchmark bond has largely traded between 7.40%-7.50% for more than a month now, comparable to the highest-yielding debt in the Asian emerging markets of Indonesia and the Philippines.
"The yield is attractive, but we don't have high conviction in the currency levels," said Jim Veneau, head of fixed income, Asia at AXA Investment Managers.
"If we feel that the rupee is stable, or would be volatile within a band, then we could say it's worth it for us to buy Indian bonds and leave them unhedged. But right now, it's not."
Several fund managers view Indian bonds as an appealing investment over the medium term but expect to start investing around the second quarter of next year, which suggests the pressure on yields may continue over the next few months.
The Indian rupee has plunged nearly 10% this year, mostly in line with its Asian peers as the U.S. dollar reigned, but its losses were exacerbated in October, when the currency also sank to a record low of 83.29.
Since then, the rupee has recovered 2% to trade near 81.60.
Honyu Fung, a senior portfolio manager at AXA IM, noted that hedged returns on a 5-year government bond in India would generate a USD-equivalent yield of 3.55%, lower than the 4.25% on the comparable U.S. Treasury.
With the U.S. Federal Reserve still in the midst of its rate hike cycle, investors are wary of taking any large positions, fund managers said.
Overseas investors have pulled around $1.93 billion from Indian debt so far this year, amid a mass exodus of funds from emerging markets.
Moreover, India's fundamentals have not instilled enough confidence, with the current account deficit expected to widen to 3.3% of GDP in 2022/23, as per a Reuters poll, and inflation staying consistently above the central bank's target band, investors said.
"But in the medium term, we do think the fundamentals for India can improve due to its high economic growth rate, continued economic reforms and ability to attract foreign direct investment", said Johnny Chen, emerging markets portfolio manager at William Blair.
If bond yields do rise to 7.75%-7.80%, we could see a lot more allocation. But if they remain around current levels in the next few months, that would be attractive too, said Wei Liang Chang, FX and credit strategist at DBS Bank.
Others held a similar view, saying China's economic slowdown this year has helped India appeal as an investment destination. Indonesia also remained another favourite when it came to buying emerging market bonds.
However, a delay in the inclusion of Indian government debt in the J.P. Morgan emerging market bond index until next year was considered a major setback.
"Allocation is mandate-specific and benchmark dependent, noted Anupam Damani, head of international and emerging markets debt at U.S.-based asset manager Nuveen.
"Given that Indian local debt is not in any benchmarks, its size would be quite limited'"
(Reporting by Anushka Trivedi; Editing by Swati Bhat and Savio D'Souza)