JPMorgan index inclusion makes target maturity funds ideal for attractive yields

As global investors start to allocate capital to Indian bonds, increased demand can be expected to drive yields lower.
As global investors start to allocate capital to Indian bonds, increased demand can be expected to drive yields lower.

Summary

  • This is a compelling opportunity for bond investors to capitalise on India's changing position in the global financial system.

India’s recent inclusion in JPMorgan's Emerging Market Bond Index (EMBI) marks a significant milestone for our country's financial markets. As someone who has long anticipated this development, I believe it presents a compelling opportunity for fixed income investors to capitalise on the changing landscape. This move is not just another headline—it’s a fundamental shift that will reshape India's position in the global financial ecosystem.

Since the announcement last year, we've witnessed a notable fall in yields, resulting in mark-to-market gains for existing bondholders. This initial movement is encouraging, but I'm convinced it's just the tip of the iceberg. The real potential for yield compression lies ahead, particularly as we look towards a future where the US Federal Reserve begins to ease its monetary policy.

Also Read: India’s entry Into JP Morgan Bond Index may assure cheaper funding

As global investors start to allocate capital to Indian bonds, we can expect increased demand to drive yields lower. This trend is likely to accelerate once the US interest rate cycle turns, making Indian bonds even more attractive on a relative basis. The confluence of India's improving economic fundamentals and the global search for yield creates a perfect storm for our bond markets.

It's also crucial to understand that while the current gains are welcome, the most significant opportunities lie in anticipating and positioning for the future trajectory of yields. Investors who act now stand to benefit not only from potential capital appreciation but also from locking in attractive yields before the market fully prices in India's new status.

Importance of TMFs

Even after the recent removal of indexation benefits, I remain bullish on Target Maturity Funds (TMFs) as a vehicle for fixed income investment. In fact, their strategic importance has only increased in light of India's inclusion in the EMBI. Here's why:

1. TMFs offer investors the chance to secure current yields for an extended period. With the potential for further yield compression, this strategy allows you to benefit from today's rates while positioning for capital appreciation.

2. By focusing on TMFs with government securities as underlying assets, we eliminate credit risk concerns. These sovereign instruments provide a high degree of safety, crucial in times of market uncertainty and transition.

Also Read: Mutual Funds: What are target maturity funds and why should you invest in them?

3. While TMFs will experience some mark-to-market volatility, holding these funds to maturity allows investors to achieve returns closely aligned with the yield-to-maturity at the time of investment, minus expenses. This predictability is invaluable in portfolio construction.

4. Even without indexation, TMFs remain tax-efficient compared with many alternative fixed income options, particularly for investors in higher tax brackets. The after-tax returns can still be compelling, especially when compared to traditional fixed deposits.

The loss of indexation benefits may have dimmed the sheen of TMFs for some investors, but this is short-sighted. The structural advantages of these funds, particularly in the context of India's evolving bond market, far outweigh the tax implications. Investors need to look beyond immediate tax considerations and focus on the total return potential and risk-adjusted benefits of TMFs.

The ‘now’ moment

But why India and why now? India's inclusion in the EMBI is not a random event or a stroke of luck. It's the culmination of years of fiscal discipline, market reforms, and improving macroeconomic fundamentals. The timing is particularly opportune, given the gap left by Russia's exclusion from the index, China's declining yields, and progress on settlement mechanisms for foreign investors.

As India gradually increases its weight in the index (potentially up to 10%), we can expect significant inflows. Conservative estimates suggest $20-25 billion could enter the Indian bond market over the next 10-12 months. This isn't just hot money - it represents a structural shift in how global investors view Indian debt.

Also Read: Why India’s inclusion in the JPMorgan bond index is a moral victory for us

A year ago, India's inclusion in global bond indices was just a possibility. Today, it's a reality that's reshaping our fixed income landscape. While some may view the loss of indexation benefits as a deterrent, I see the current environment as an exceptional opportunity to position portfolios for the future.

By strategically allocating to TMFs, investors can lock in attractive yields, manage risk, and potentially benefit from the structural changes unfolding in India's bond market.

Remember, it's often said that the best time to plant a tree was 20 years ago, and the second-best time is now. India's entry into global bond indices may well be that "now" moment for fixed income investors. The stage is set for a transformation in our bond markets, and those who position themselves wisely stand to reap significant benefits in the years to come.

Arihant Bardia, CIO and Founder, Valtrust.

 

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