Foreign investors have moved decisively into short-term Indian government bonds in recent months, favoring notes with maturities under five years as they seek entry points ahead of an expected policy inflection and amid rising inflation concerns connected to the Iran war.
Clearing house records show that bonds maturing in less than five years accounted for more than two-thirds of the top 10 notes bought by overseas investors during March-May. That is a notable shift from January-February when such short-dated securities made up under half of similar purchases.
Activity patterns over the first five months of the year underline the change in sentiment. Overseas investors were net buyers of 221 billion rupees of government bonds in January-February, then recorded a record net sale of 177 billion rupees in March, before returning to the buyer side in April-May.
Yields across the curve have climbed over the last three months, with shorter-duration yields - those most sensitive to policy moves - rising particularly sharply as markets priced in higher inflation resulting from an Iran war-linked energy shock. Between March and May the 10-year benchmark yield increased by 34 basis points, while the five-year yield rose by 55 basis points, compressing the five-year/10-year spread to an eight-month low of 15 basis points.
Market participants point to an emerging expectation of tighter monetary policy. "Investors are increasingly factoring a shift toward tighter policy," said Krishna Bhimavarapu, APAC economist at State Street Investment Management. While the Reserve Bank of India is widely expected to hold rates at the June meeting, the policy direction is clearly shifting, he said.
"In such an environment, the front end (of the yield curve) offers more attractive risk-adjusted carry with lower duration risk, while the long end remains vulnerable to further repricing if the tightening cycle materialises."
That repricing and the relative move in short versus long yields has created what some market strategists call a valuations-driven opportunity. "The curve has bear flattened with short-end yields rising more than the long-end yields. This has created a valuations-driven opportunity for foreign investors to buy short-end bonds," said Nagaraj Kulkarni, chief rates strategist - South Asia & Indonesia and head - flows strategy at the foreign bank.
The Reserve Bank of India is due to announce its rate decision on Friday. Most economists surveyed expect a pause at that meeting, although Standard Chartered has publicly called for a 25-basis-point hike. Market participants will be watching how the central bank frames its assessment of inflation and external risks.
For reference, the dollar-rupee conversion used in market commentary is $1 = 95.7800 Indian rupees.
Context and implications
Short-dated government securities have become the preferred entry point for overseas demand as they offer higher carry with reduced sensitivity to further rate moves. The longer end of the curve remains exposed should a sustained tightening cycle materialise, leaving investors divided along duration lines as they weigh inflation and policy risks.