Worst Returns Among Asian Bonds Poised to Become Best Bets: India Credit

India, the bond market’s worst- performer in Asia this year, is poised to provide some of the biggest returns in the region as investors get the benefit of the highest relative yields converging with slowing inflation.

Government notes returned 3 percent this year, the weakest performance among 10 Asian local-currency debt indexes compiled by HSBC Holdings Plc. The yield on notes due in 2015 rose to a 23-month high of 7.76 percent this week, 75 basis points more than the fixed cost for funding using interest-rate swaps and the biggest premium among 10 major markets in the region, according to data compiled by Bloomberg.

Investors are gaining more confidence in central bank Governor Duvvuri Subbarao after the inflation rate fell below 10 percent in July for the first time in six months. Morgan Stanley and Standard Chartered Plc recommend investors buy bonds with fixed borrowing costs.

“Yields look close to a peak as the runaway acceleration in inflation has stopped,” Manoj Swain, the chief executive officer at Morgan Stanley India Primary Dealer in Mumbai, a unit of the New York-based bank, said in an interview yesterday. “People should buy bonds and pay fixed swap rates.”

Five-year yields have added 47 basis points, or 0.47 percentage point, in 2010, extending 2009’s record 186 basis point advance, as the average inflation rate jumped sevenfold to 10.5 percent. The notes yield the most among Asia’s local- currency debt markets excluding Pakistan and Vietnam, data compiled by Bloomberg show.

Slowing Inflation

The five-year swap rate, a fixed cost to receive a variable payment, slid 42 basis points from a two-year high of 7.42 percent reached on Aug. 5 as annual wholesale-price gains decreased for a second month in August to 8.5 percent, a government report showed this week. The central bank predicted in July that the rate will decline to 6 percent by March.

The difference between the bond and swap rates will narrow 30 basis points in three months, Morgan Stanley predicts. A drop in the five-year yield of that magnitude would deliver an annualized return of 13 percent, Bloomberg data show.

Locking in a fixed rate in money markets makes sense because five-year swap rates are poised to rebound as quarterly corporate-tax payments drain cash from banks, Standard Chartered and Morgan Stanley said. Swap rates in India are pegged to the cost at which banks borrow overnight from one another and track fluctuations in that measure.

‘Historical Averages’

“Bond-swap spreads will narrow toward historical averages as tax outflows tighten cash,” Arvind Sampath, the head of interest-rate trading at Standard Chartered, the London-based lender that earns most of its profit from Asia, said in an interview yesterday. The rate difference between bonds and swaps due in five years will shrink to 50 basis points, Mumbai-based Sampath said, without specifying a time frame. The gap has averaged 40 basis points since 2005.

Indian lenders borrowed every day from the central bank since Sept. 9 to bridge cash shortages after domestic companies paid taxes. They raised 221.4 billion rupees ($4.8 billion) at the Reserve Bank of India’s securities-repurchase auction on Sept. 14, the most in a month. The overnight borrowing rate between banks climbed to 5.75 percent yesterday from 4.65 percent at the start of the month.

Central Bank

Subbarao, who has raised the benchmark repurchase rate by 1 percentage point this year, will today boost the measure by a quarter percentage point to 6 percent, according to 11 of 16 economists surveyed by Bloomberg, with five forecasting no change. Thirteen predict an increase of that much or more in the reverse repurchase rate.

The spread between the RBI’s reverse repurchase rate and the price of the one-year swap, a measure of expectations for changes in borrowing costs, peaked last month at 196 basis points, the most since October 2008. The spread is now at 171.

Foreign holdings of India’s corporate and government debt more than doubled in 2010 to touch an all-time high of $16.4 billion on Sept. 13 as yields rose. Five-year government bonds now yield 7.45 percentage points more than the three-month dollar London interbank offered rate, a measure of funding costs for global investors that is currently at 0.29 percent. The spread is near the widest since September 2008.

Yield Difference

Swings in yields on Indian bonds due 2015 have narrowed from a two-month high of 12 percent on Aug. 24, signaling a smaller potential for losses. A measure of the five-year yield’s 10-day volatility fell to 7.3 percent yesterday, data compiled by Bloomberg show. The gauge peaked in February this year, rising as high as 27.5 percent.

Indian bonds also were Asia’s worst performers in 2009, losing 5 percent, according to indexes compiled by London-based HSBC Holdings, Europe’s largest bank. Indonesia’s securities rewarded investors with a return of 22 percent last year. The notes have returned 17.3 percent this year, the best performance in the region for a second straight year.

India’s five-year bonds offer an extra yield of 629 basis points over similar-maturity securities in the U.S., near a two- year high of 641 reached Aug. 24, data compiled by Bloomberg show. The difference is 637 basis points over comparable bonds in Germany and 742 over bonds in Japan.

Boosting Rupee

The accelerated debt inflows have helped the rupee rebound almost 3 percent from an eight-month low of 47.745 per dollar reached on May 25, data compiled by Bloomberg show. The currency, which has advanced 0.4 percent this year, traded at 46.3650 yesterday.

“The bond market is entering a consolidation phase,” J. Moses Harding, a Mumbai-based executive vice president at IndusInd Bank Ltd., the second-best performer this year on the Bombay Stock Exchange’s index of bank shares, said in an interview yesterday. “With inflation stabilizing, there are no significant negatives now on the horizon for bond investors.”