Indian bonds retain shine as Fed gears up to raise rates

By Rafael Nam and Karen Rebelo

MUMBAI (Reuters) - India's debt markets are attracting foreign funds even as higher U.S. rates and concerns about China are leading to selling in other emerging markets, a remarkable turnaround for a country rocked two years ago by its worst crisis in decades.

Foreign investors bought a net $36.84 million in Indian debt in August, a small but significant amount given China's yuan devaluation sparked outflows in countries such as Indonesia, in the biggest sell-off since the "taper tantrum" of 2013.

At that time, India's bond market suffered substantial outflows due to U.S. rate hike worries, a record high current account deficit, double-digit inflation and a plunging rupee currency. There were $12 billion in outflows from May to September, the most among emerging markets tracked by HSBC.

But sentiment has turned around due to improved macro-economic stability and a stronger rupee. As the Fed gears up to raise U.S. interest rates as early as this week, India looks set to outperform its emerging market peers.

Demand for India's benchmark 10-year bonds has sent yields down around 5 basis points. In contrast, Indonesia's 10-year bond yields are up around 76 bps.

"Some of the other Asian markets are more exposed to the confluence of risks than India, including that stemming from uncertainty around the Fed, weak commodities, China and high foreign investor exposure," said Kenneth Akintewe, a fund manager for Aberdeen Asset Management.

"In terms of commodities, India actually benefits from falling commodity prices," Akintewe said, noting another plus factor was the expectation that the Reserve Bank of India (RBI) would further cut rates.

He said Aberdeen was also most overweight in onshore China debt, as well as Indonesia, South Korea and Sri Lanka.

The optimism in bond markets contrasts with a more cautious view in equity markets, which fell 6.6 percent in August after record monthly sales from foreign investors reducing their overweight positions.

PASSAGE TO INDIA

Foreign investors have now bought a net $7.8 billion in Indian bonds this year, nearly exhausting their $30 billion allocation for government bonds. They have used up 76 percent of their $50 billion limit in corporate debt.

Foreign investor exposure to Indian debt is relatively small compared to some other emerging markets due to regulatory limits. Analysts say these limits will help insulate the market from a sell-off when the Fed raises rates.

Also reassuring foreign investors is subdued consumer inflation which eased to a record low of 3.66 percent in August, far from the double digit levels in 2013.

Easing inflation is expected to spur the RBI to cut the key lending rate by a further 25 bps later this month, for a total of one percentage point this year.

Meanwhile, India's current account gap narrowed to 1.2 percent of gross domestic product in the April-June quarter, far from the record high of 4.8 percent in the year to March 2013, while the government has pledged to keep its fiscal deficit at 3.9 percent of GDP in the year to March.

India has boosted foreign exchange reserves too. They are near a record $355.459 billion hit in mid-June, enough to cover imports for nine to 10 months.

"Macroeconomic fundamentals of India are significantly better than its emerging market peers," said Nagaraj Kulkarni, a senior rates strategist at Standard Chartered in Singapore.

Kulkarni added India is only the second country besides China in which Standard Chartered has a "positive" outlook.

(Additional reporting by Swati Bhat in MUMBAI, Fransiska Nangoy in JAKARTA, Satawasin Staporncharnchai in BANGKOK, Yantoultra Ngui in KUALA LUMPUR, Choonsik Yoo in SEOUL, and Simon Jessop in LONDON; Editing by Jacqueline Wong)