India is set to become one of the largest exposures in emerging bond indices after its government bonds officially became part of JPMorgan benchmarks on June 28. India’s inclusion is likely to benefit investors, managers say, bringing greater diversification and higher returns.
India's macroeconomic outlook has strengthened in recent years as it bids to become a new global superpower. The country's solid economic fundamentals, including robust growth, stable inflation and ample foreign exchange reserves, have boosted confidence in the strength of its bond market.
"Once completed, India is expected to have a 10% weighting in the JPM GBI-EM Global Diversified benchmark index. Other benchmarks will also change and India's weight will vary. In any case, India will become one of the largest exposures in emerging bond indices, along with other major issuers such as China, Indonesia or Mexico,” says Jose Garcia-Zarate, head of passive strategies research at Morningstar.
The rollout will take place gradually over 10 months, at an inclusion rate of around 1% per month, he adds.
Go Active or Passive on EM Debt?
Investors have a range of ways into EM debt, but they are not equal in terms of risk.
"On paper, the complexity of the emerging bond universe would justify an active approach, as managers may be able to pick the right bets in terms of country and currency exposure," Garcia-Zarate comments.
"However, active bets on emerging market debt remain fraught with risk, whereas a low-cost, broad-based passive approach balances them out in the long run. This has resulted in a more stable risk/return profile for index funds than the average of competitors in the Morningstar category, and this is likely to remain the case going forward."
To date, there are six local currency emerging market bond exchange-traded funds among those domiciled in Europe.
Well-diversified passive funds have performed well in the context of their Morningstar category, which also includes active products. In particular, passive strategies that track to indices with a quality bias proved better at cushioning the downside and provided higher returns over the long term.
India Brings Performance and Diversification
In an interview with Morningstar, Pradeep Kumar, emerging markets debt manager at PGIM Fixed Income, said: "In its current form, the GBI-EM index needs more countries with higher yields and a low correlation with the US Treasury market. After the exclusion of Russia in 2022 and the collapse of Chinese bond yields, the index's overall spread against US yields has narrowed significantly."
The combined weight of China, Malaysia and Thailand is 30% and the bond yields of these countries are below 4%.
"With a 7% return in the India sub-index, its inclusion will not only increase the overall index return but also add diversification. The Indian bond market has a much lower correlation than the core bond markets and local idiosyncratic factors are much more crucial than global ones," Kumar added.
According to Pramol Dhawan, head of emerging market portfolios at PIMCO, in an interview with Morningstar: "The introduction of India will increase the index's return by 6 basis points, while reducing its volatility."
The manager points out that the index will become more diversified and will be better able to provide a smoother stream of returns as more countries become eligible for inclusion.
"The index weightings will gradually increase by 1% per month, leading to an inflow of around $35 billion into the Indian local currency bond market. This change is expected to have a minimal impact on spreads, as it has been well communicated, but more importantly it will greatly improve liquidity conditions," Dhawan explained.
Emerging Markets are Still Risky
It should be noted that investors wishing to access the Indian government bond market have been able to do so for some years now through various ETFs that track a 100% Indian bond index. For example, the L&G India INR Government Bond ETF, launched in 2021, has gathered a fair amount of assets.
"However, for most investors, allocation to emerging markets is rarely done through bets on a single country and they prefer to opt for broadly diversified country strategies," continues Jose Garcia-Zarate.
This is because emerging markets have multiple risk factors, in particular monetary policy movements and politics. For this reason, a diversified approach helps hedge the risk of too much exposure to a single country, which is why India's inclusion in the overall benchmarks is particularly appreciated by the market.
"With India's entry, investors in broad-based emerging bond funds should expect an increase in Asian exposure at the expense of other geographies," Garcia-Zarate says.
"It is expected that the European emerging market group will be the one that will suffer the biggest drop in weight. This means that current investors in these funds should prepare for a change in their exposure, although they will continue to benefit from a wide diversification at the country level."
Opportunities in Emerging Local Currency Debt
After a long period of underperformance, emerging local currency debt is back in the spotlight. This trend is also due to the fact that the US dollar, which has risen relentlessly for the past 15 years, may have started to come to a halt.
As can be seen in the chart below compared to a basket of emerging currencies, the dollar appreciated by almost 50% on a trade-weighted basis between June 2008 and October 2022. The result was a US dollar overvalued by more than 10% and emerging market currencies undervalued by more than 20%. This has been tough for emerging economies, which have suffered from dollar strength in several forms: lower investment, higher debt costs, and strong inflationary pressures.
The dollar's strength has been more or less universal: it has risen against almost all currencies, in both emerging and developed markets. Now with the expected change in monetary policy by the Federal Reserve, the possible reversal - or even just a sideways movement - of the dollar should support emerging market assets.
"We are cautiously optimistic on local bonds. Our base case scenario is for the Fed to cut rates once or twice in 2024 and extend the easing cycle in 2025," Pradeep Kumar said.
"We believe that significant value has been created in light of current starting yields and that emerging market investments will bring significant variety and yield enhancement to global fixed income portfolios," ramol Dhawan added.
Indeed, during 2023, expectations of a less aggressive Fed helped attract new investments to emerging market bond markets, after investors had abandoned the asset class following recurring rate hikes in the previous year.
US Inflation and the 2024 Election
When taking exposure to emerging markets there are several factors that should be taken into account. Compared to their developed counterparts, emerging market bonds are riskier, typically more illiquid and have higher transaction costs. In short, despite the more promising outlook, those investing in emerging market bonds should be aware of the risks.
"The main risks stem from a pick-up in US inflation, which would lead to a sell-off in US rates, and the failure to consolidate fiscal deficits in Brazil and Mexico. The outcome of the US presidential election and the post-election US fiscal outlook could also put pressure on rates and local currencies," PGIM's Kumar said.
Moreover, while offering more attractive yields, emerging market bonds now face increased competition from developed market government bonds, that are significantly less risky and offer real yields.
